The price-to-sales (P/S) ratio is a profitability analysis tool used to compare companies and discover undervalued securities. As with all equity valuation metrics, P/S ratios can vary significantly between industries and companies, so it's important to view a company's P/S ratio in comparison to similar companies within the same industry. In general, the lower the P/S ratio calculation, the more attractive the investment.
- The P/S ratio measures how much equity investment from investors is needed to deliver $1 of revenue.
- The P/S compares the company's market capitalization to the company's revenue from the past 12 months.
- The ratio is most useful when comparing similar companies in similar industries.
- You can calculate the ratio on a per-share basis or a company-wide basis.
- When comparing similar companies, the company with a lower P/S ratio will be a more favorable investment.
The Price-to-Sales Ratio
The P/S ratio is an investment valuation ratio that shows a company's market capitalization divided by the company's sales for the previous 12 months. It is a measure of the value investors are receiving from a company's stock by indicating how much equity is required to deliver $1 of revenue.
The metric is also called the revenue multiples or sales multiples. Analysts prefer to see a lower number for the ratio. A ratio of less than 1 indicates that investors are investing less than $1 for every $1 the company earns in revenue.
When to Use the Price-to-Sales Ratio
The P/S ratio is most useful in several situations. First, the ratio should only be used when comparing similar companies within similar industries against each other. As different entities and different sectors have varying capital requirements, the P/S ratio of one industry may vary greatly from the ratio of another.
The P/S ratio is also useful when analyzing companies with similar financing structures especially considering companies that do not carry debt. As the P/S ratio does not consider debt financing, two companies earning the same total revenue can have different P/S ratios if one is highly leveraged while the other relies heavier on share offerings.
The metric can be calculated based on aggregate totals or on a per-share basis:
Price-to-Sales Ratio = Total Company Market Capitalization / Total Company Sales
Price-to-Sales Ratio = Market Value per Share / Sales per Share
The P/S ratio is considered a particularly good metric for evaluating companies in cyclical industries that may not show an actual net profit every year. Because the P/S ratio considers a company's past 12 months of revenue, it absolves any cyclicality or seasonality. The P/S ratio is not as useful when analyzing young emerging companies as the metric does not consider the future growth potential.
Last, the P/S ratio is useful when analyzing companies with negative earnings or negative cash flow. The ratio only looks at a company's revenue and not its operating expenses or profit margin. Therefore, though companies may not be profitable, the P/S ratio analyzed over time can detect revenue growth and emerging efficiencies in operations before the company ends up turning a profit.
What Does a High Price-to-Sales Ratio Indicate?
Higher P/S ratios may indicate a company is not efficiently using investor funds to drive revenue. When comparing similar companies across similar industries, lower P/S ratios are more favorable.
What Is the Average Price-to-Sales Ratio?
Each industry will have its own average P/S ratio. What might be average P/S for one sector may be considered a very high or very low ratio for another.
How Do You Analyze Price-to-Sales Ratio?
A P/S is analyzed by comparing it against similar companies or industries. Investments with lower P/S ratios are generally more attractive as this indicates the company is generating more revenue for every dollar investors have put into the company.