Wednesday, September 14, 2011

Price to Sales Ratio or P/S ratio to Value Stock

Definition: Price to Sales Ratio (PSR or P/S ratio) is calculated by dividing the company's market cap by the company's revenue; or, dividing the stock price per share by the revenue per share. It indicates how much investor paid for a share compared to the sales generated (per share) by the company. A lower ratio is considered a better investment as the investor is paying less for each unit of sales.

Price to sales ratio = Market price per share / Sales per share
PSR = Market Capitalization / Total sales

Example 1:
If a company has a market cap of $20 million and revenue of $10 million. Then, the P/S ratio = 20 million / 10 million = 2

Example 2:
A corporation with sales per share of $35 and a share price of $105 would have a P/S ratio of 3 (Calculation: 105 / 35 = 3). This means that investors pay $3 for every dollar of sales that the corporation generates.

Example 3:
Wayne Ltd has sales of $20 billion and the stock has a total market capitalization of $18 billion, then the Price to sales ratio for Wayne Ltd is: 18 billion / 20 billion = 0.9

Another example:
The price-to-sales ratio helps determine a stock’s relative valuation. The formula to calculate the P/S ratio is:
P/S Ratio = Price Per Share / Annual Net Sales Per Share

Let's assume Company XYZ reports net sales of $5,000,000 and it currently has 500,000 shares outstanding. The stock is currently trading at $20.

Sales per Share = (5,000,000/500,000) = 10
Price-to-Sales Ratio = 20/10 = 2

Now we want to compare XYZ to one of its competitors, Company ABC.
ABC also reports net sales of $5,000,000 and it also has 500,000 shares outstanding. The stock is trading at $100.

Sales per Share = (5,000,000/500,000) = 10
Price-to-Sales Ratio = 10/10 = 10

Investors in ABC are willing to pay $10 for $1 in sales, while investors in XYZ are willing to only pay $2 for $1 in sales. Any number of scenarios could explain this discrepancy, so it's important to know what makes ABC stock so much more appealing. If you can't find a good reason, perhaps stock XYZ is undervalued, and represents a good bargain

Why It Matters:

Price-to-sales ratio is considered a relative valuation measure because it's only useful when it's compared to the P/S ratio of other firms. The P/S ratio varies dramatically by industry. For example, retail companies typically display a much higher P/S ratio than companies highly involved in research and development.

Therefore, when comparing P/S ratios, make sure the firms are within the same industry.
The P/S ratio is useful because sales figures are considered to be relatively reliable. Other income statement items, like earnings, can be easily manipulated by using different accounting rules. 

Even though sales are difficult to manipulate, it's not impossible. Always read financial statements thoroughly to understand the firm's revenue recognition policy. One of Enron's accounting tricks was to recognize revenue earlier than it should have, enabling it to report inflated sales figures.

P/S is appropriate to use when valuing most types of stock. But note that P/S should never be the sole metric used when valuing a company. For example, a business may have higher sales but a lower profit margin than a competitor, indicating that it's not operating efficiently
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