By Richard Loth (Contact | Biography)
A stock's price/sales ratio (P/S ratio) is another stock valuation indicator similar to the P/E ratio. The P/S ratio measures the price of a company's stock against its annual sales, instead of earnings.
Like the P/E ratio, the P/S reflects how many times investors are paying for every dollar of a company's sales. Since earnings are subject, to one degree or another, to accounting estimates and management manipulation, many investors consider a company's sales (revenue) figure a more reliable ratio component in calculating a stock's price multiple than the earnings figure.
The dollar amount in the numerator is the closing stock price for Zimmer Holdings as of December 31, 2005, as reported in the financial press or over the internet in online quotes. In the denominator, the sales per share figure is calculated by dividing the reported net earnings (income statement) by the weighted average number of common shares outstanding (income statement) to obtain the $13.30 sales per share figure. By simply dividing, the equation gives us a P/S ratio indicating that, as of Zimmer Holdings 2005 fiscal yearend, its stock (at $67.44) was trading at 5.1-times the company's sales of $13.30 per share. This means that investors would be paying $5.10 for every dollar of Zimmer Holdings' sales.
"The king of the value factors" is how James O'Shaughnessy describes the P/S ratio in his seminal book on investing strategies, What Works on Wall Street (McGraw-Hill, 1997). Using Standard & Poor's CompuStat database, his exhaustive analysis makes clear that "the stock market methodically rewards certain investment strategies while punishing others." No matter what your style of investing, O'Shaughnessy's research concludes that "low price-to-sales ratios beat the market more than any other value ratio, and do so more consistently."
As powerful a valuation metric as the P/S ratio may be, it would be a mistake for investors to put all their stock price valuation eggs in one basket. However, the P/S ratio does provide another perspective that complements the other valuation indicators - particularly the P/E ratio - and is a worthwhile addition to an investor's stock analysis toolbox.
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