How to use Price-to-Sales Ratio?

P/S Ratio

How to use Price-to-Sales Ratio?

What is Price-to-Sales Ratio ?

Investors are always seeking ways to compare the value of stocks. The price-to-sales ratio utilizes a company’s market capitalization and revenue to determine whether the stock is valued properly. This ratio is very useful because it states the valuation of a company in context of one the easiest to understand financial metric (i.e. revenue).

Definition : Price-to-sales ratio

  • Price to Sales Ratio is also called as the P/S ratio or simply Price/Sales, where Price is the current market price of the stock and Sales is the annual sales per share.
  • P/S Ratio is a valuation metric for stocks that compares company’s stock price to its revenue. It is a financial ratio that measures the value, investors put on a company for each rupee of revenue generated by the company.
  • Generating revenue from sale of goods or services is the most fundamental operations of a company. So this P/S ratio describes the valuation of the company based on its actual operations without impacting for accounting adjustments.
  • This ratio is also very useful for companies which have negative or zero net earnings such as start-ups.
What is Price-to-Sales Ratio?
What is 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 “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, market is ready to pay Rs. 5 currently.

what does price-to-sales ratio reveal?

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

examples

Example 1:

Price-to-Sales Ratio of Company ABC
Price-to-Sales Ratio of Company ABC
  • Share Price and Sales per Share information of company ABC is 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 Price/Sales basis in the three years.
  • In other words, investors are paying more money to invest in this company compared with its level of sales 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. This could be caused by market trends, company dominance in the industry, or simply investor speculation.

Example 2:

Price-to-Sales Ratio Data of Maruti Suzuki, Tata Motars and Eicher Motors
Price-to-Sales Ratio Data of Maruti Suzuki, Tata Motors and Eicher Motors
Source : Moneycontrol.com
  • Now let us consider real world example of auto giants: Maruti Suzuki, Tata Motors and Eicher Motors. Above table shows the Price to Sales ratio for the companies for past three years 2018, 2017 and 2016. Of course these companies compete under various business segments, but also have some diverging lines of business.
  • As we can see, Maruti Suzuki’s P/S ratio has increased over the past three years while in case of both Tata Motors and Eicher Motors’s P/S ratios have first increased in 2017 and then 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 is still having a higher premium than that of both Maruti Suzuki and Tata Motors. A very high P/S Ratio can be a warning sign.

how price-to-sales ratio is useful?

  1. The price-to-sales ratio shows how much the market value every rupee of the company’s sales. This ratio can be effective in valuing 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 industry that are profitable, 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 properly.
  3. In a highly cyclical industry such as semiconductors, there are years when only a few companies produce any earnings. This 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 be able to 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 useful, 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.
  • Low P/S ratio can indicate unrecognized 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.

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