How to use Price-to-Sales Ratio?

The price-to-sales (P/S) ratio is a valuation ratio that compares the stock price of a company to its revenues. It is the monetary worth that financial markets have assigned to each dollar of a company’s sales or revenues.

What is Price to Sales Ratio?

Investors are constantly seeking ways to compare the value of stocks. The price-to-sales Ratio utilizes a company’s market cap to sales ratio and revenue multiple formulae to determine whether the stock is appropriately valued. This Ratio is beneficial because it states the valuation of a company in the context of one the easiest to understand financial metrics (i.e. revenue).

Definition: Price to sales ratio

• Price to Sales Ratio is also called the P S Ratio or simply Price/Sales, where ps value is the stock’s current market price per share formula and Sales is the annual sales per share.
• P S Value is a stock valuation metric that compares a company’s stock price to its revenue. A financial ratio measures the value investors put on a company for each rupee of revenue generated by the company.
• Generating revenue from the sale of goods or services is the most fundamental operation of a company. So this P/S Ratio describes the company’s valuation based on its actual operations without impacting accounting adjustments.
• This Ratio is also beneficial for companies with negative or zero net earnings, such as start-ups.

Price to Sales Ratio Formula: P/S ratio

1. Price to Sales Ratio formula is: P/S Ratio = [Current Market Price of stock / Annual Sales per Share]
2. Another formula of P/S Ratio is, P/S Ratio = [Market Capitalization / Total Sales or Revenue over the past 12 months] Where,
   ○ Market Capitalization = [No. of Outstanding Shares * Market Price] and Total Sales is the top line of the income statement of a company.
   ○ Number of outstanding shares is also available in the income statement or notes to accounts of an annual report.
   ○ Sales used in the above formula can be ‘Last reporting year’, ‘last calendar year’ or ‘forecasted reporting year’.
   ○ The most commonly used are ‘TTM –trailing twelve months’, ‘LTM – last twelve months’ and ‘NTM – next twelve months’.
3. P/S Ratio is also known as “PSR,” “Sales multiple,” or “Revenue multiple.”
4. A P/S ratio calculated on forecasted earnings is called the “Forward Ratio.”

How to Calculate Price-to-Sales Ratio?

For example, if the Annual sale of a company in a certain FY is 100 cr while there are 10 cr shares of this company in the market and the stock is trading at Rs. 50. The P/S Ratio would be calculated as Annual sales per share = [100 cr/10 cr] = 10. P/S Ratio = [Market Price per share/ Annual Sales per Share] = [50/10] = 5. So, for every rupee earned by the company in sales, the market is ready to pay Rs. 5 currently.

What does the price-to-sales Ratio reveal?

• Generally, the lower the ratio the better it is as it might indicate undervaluation of a company: the lower the P/S Ratio, the more attractive the investment. Price-to-sales provides a valuable measure for sizing up stocks.
• Now, the market price of a stock also increases in anticipation of future earnings so that the market price would be high. When comparing two stores, you might pick a stock with a lower P/S Ratio as the stock looks undervalued, but it should also have a steady rise in sales so that the bet turns out beneficial for you, but it doesn’t, you might have to bear a loss. Hence, before picking a stock evaluating other parameters is essential too.
• The Price to Sales ratio is more relevant to compare companies of the same sector. A lower ratio indicates undervaluation, and an above-average ratio suggests overvaluation.
• A company’s stock price may increase in anticipation of a rise in revenue expected, leading to a higher PSR than its peers.
• Not to forget, PSR should not be seen in isolation, and all the other parameters of the stock should be analysed before buying it. PSR is more helpful in evaluating early-stage companies as the rise in revenue can be substantial in the early stages.

Examples

Example 1:

Price-to-Sales Ratio of Company ABC

• Share Price and Sales per Share information of company ABC are presented, and Price-to-Sales Ratio is also calculated in the table above.
• We can see that in the three years under consideration, the share price has increased by 50% (10 to 15) while sales have grown at a slower pace; hence the company has become more costly on a Price/Sales basis in the three years.
• In other words, investors are paying more money to invest in this company than its sales level today than investors were 3 years ago.
• We can see that in year 1, investors were willing to pay Rs.1.25 for every rupee of sales a share made. In year 3, investors were willing to pay Rs.1.50 for each rupee of sales. It could be caused by market trends, company dominance, or simply investor speculation.

Example 2:

Price-to-Sales Ratio Data of Maruti Suzuki, Tata Motors and Eicher Motors

Source: Moneycontrol.com

• Now let us consider real-world examples of auto giants: Maruti Suzuki, Tata Motors and Eicher Motors. The above table shows the Price to Sales ratio for the companies for the past three years, 2018, 2017 and 2016. Of course, these companies compete under various business segments and have some diverging business lines.
• As we can see, Maruti Suzuki’s P/S Ratio has increased over the past three years, while in the case of both Tata Motors and Eicher Motors’s P/S ratios which have risen first in 2017 have seen a decrease in the figures in 2018.
• It shows us that investors are willing to pay a higher premium for Maruti Suzuki stock relative to its earnings than Tata Motors. Eicher Motors’s stock has a higher premium than that of both Maruti Suzuki and Tata Motors. A very high P/S Ratio can be a warning sign.

How is the price-to-sales Ratio applicable?

1. The price-to-sales Ratio shows how much the market values every rupee of the company’s sales. This Ratio can effectively value growth stocks that have yet to turn a profit or have suffered a temporary setback.
2. For example, if a company isn’t earning a profit yet, investors can look at the P/S Ratio to determine whether the stock is undervalued or overvalued. If the P/S Ratio is lower than comparable companies in the same profitable industry, investors might consider buying the stock due to the low valuation. Of course, the P/S Ratio needs to be used with other financial ratios and metrics when determining whether a stock is valued correctly.
3. In a highly cyclical industry such as semiconductors, there are years when only a few companies produce any earnings. It does not mean semiconductor stocks are worthless. In this case, investors can use price-to-sales instead of the price-earnings Ratio (P/E Ratio) to determine how much they are paying for a dollar of the company’s sales rather than a dollar of its earnings. If a company’s earnings are negative, the P/E Ratio is not optimal since it will not value the stock because the denominator is less than zero.

Summary

• The P/S Ratio provides a way to value a company with little or no profits.
• A higher P/S ratio relative to peers or the industry may suggest a company is overvalued, while a lower P/S ratio suggests a company is undervalued.
• A P/S ratio comparison of companies in different industries might not be helpful, given the differences in needed expenses to generate profits or pay debts.
• As with all valuation techniques, sales-based metrics are only part of the solution. Investors should consider multiple metrics to value a company.
• A Low P/S ratio can indicate unrecognised value potential- so long as other criteria exist, like high-profit margins, low debt levels, and high growth prospects. Otherwise, the P/S Ratio can be a false indicator of value.