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The price-to-sales ratio (PSR) is a useful metric for determining the value the market places on each dollar of a company’s revenue.  The ratio can be calculated in a number of ways, but the most common is to divide the company’s total market capitalization by a year’s worth of sales.  Generally, the sales number is the past 12 months of sales.  By using projected sales figures for the upcoming year, the forward-looking price-to-sales ratio can also be estimated.

A company’s PSR should only be compared to other companies in the same industry.  A low PSR is usually indicative of a stock that is undervalued by the market.  Conversely, a high PSR may indicate an overvalued stock.

ABC Inc. is a publicly traded company.  Its prior 12 months income equals \$600 million.  ABC has 20 million shares outstanding and the price per share is \$25.

ABC’s total market capitalization is \$500 million.  Dividing that by the \$600 million prior 12 month’s sales yields a PSR of .83.  If the average PSR in ABC’s industry is 1.2, then ABC’s stock is undervalued compared to its peers.

Now assume ABC’s projected sales for the next 12 months is \$400 million.  Under this scenario, ABC’s PSR is 1.25, which is a little above the industry average and indicates a stock price that is on target in that industry.  Thus, investors have already considered ABC’s drop in sales for the coming year and the market price of its stock reflects that.

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