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.

How the Price-to-sales Ratio Works

The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company's total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. Price-to-sales provides a useful measure for sizing up stocks.

How P/S Is Useful

The price-to-sales ratio shows how much the market values every dollar of the company's sales. The price-to-sales ratio can be effective in valuing growth stocks that have yet to turn a profit or have suffered a temporary setback.

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.

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 or PE) 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 since the denominator would be less than zero.

The price-to-sales ratio can be used for spotting recovery situations or for double-checking that a company's growth has not become overvalued. It comes in handy when a company begins to suffer losses and, as a result, has no earnings with which investors can assess the shares.

Let's consider how we evaluate a firm that has not made any money in the past year. Unless the firm is going out of business, the P/S will show whether the firm's shares are valued at a discount against others in its sector. Let's say the company has a P/S of 0.7 while its peers have a 2.0 for P/S. If the company can turn things around, its shares will enjoy substantial upside as the P/S becomes more closely matched with those of its peers. Meanwhile, a company that goes into a loss (negative earnings) may also lose its dividend yield. In this case, P/S represents one of the last remaining measures for valuing the business. All things being equal, a low P/S is good news for investors, while a very high P/S can be a warning sign.

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How To Use Price-To-Sales Ratios To Value Stocks

Where P/S Fall Short

That being said, turnover is valuable only if, at some point, it can be translated into earnings. Consider construction companies, which have high sales turnover, but, with the exception of building booms, make modest profits. By contrast, a software company can easily generate $4 in net profit for every $10 in sales revenue. What this discrepancy means is that sales dollars cannot always be treated the same way for every company.

Some investors view sales revenue as a more reliable indicator of a company's growth. Although earnings is not always a reliable indicator of financial health, sales revenue figures can be unreliable too.

Comparing companies' sales on an apples-to-apples basis hardly ever works. Examination of sales must be coupled with a careful look at profit margins and compare the findings with other companies in the same industry.

Debt Is a Critical Factor

The price-to-sales ratio does not account for the debt on a company's balance sheet. A firm with no debt and a low P/S metric is a more attractive investment than a firm with high debt and the same P/S. At some point, the debt will need to be paid off, and the debt has an interest expense associated with it. The price-to-sales ratio as a valuation method doesn't consider that companies with high debt levels will ultimately need higher sales to service the debt.

Companies heavy with corporate debt and on the verge of bankruptcy, however, can emerge with low P/S. This is because their sales have not suffered a drop while their share price and capitalization collapses.

So how can investors tell the difference? There is an approach that helps to distinguish between "cheap" sales and less healthy, debt-burdened ones: use enterprise value/sales rather than market capitalization/sales. Enterprise value includes a company's long-term debt into the process of valuing the stock. By adding the company's long-term debt to the company's market capitalization and subtracting any cash, one arrives at the company's enterprise value (EV). Think of EV as the total cost of buying the company, including its debt and leftover cash.

The Bottom Line

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 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 can be a false indicator of value.