Investors are at all times seeking ways to compare the value of stocks. The price-to-sales ratio utilizes a company’s market capitalization and revenue to judge 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 winning a company’s market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company’s total tradings or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. Price-to-sales provides a fruitful 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 comrades’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 passing 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 relationship is lower than comparable companies in the same industry that is profitable, investors might consider buying the look at 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 deal in is valued properly.
In a highly cyclical industry such as semiconductors, there are years when only a few companies in any earnings. This does not mean semiconductor stocks are worthless. In this case, investors can use price-to-sales instead of the price-earnings relationship (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 assemblage’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 proportion 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 troop 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 unyielding 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 unshakeable’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 guests can turn things around, its shares will enjoy substantial upside as the P/S becomes more closely matched with those of its peers. In the intervening time, a company that goes into a loss (negative earnings) may also lose its dividend yield. In this package, 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 great P/S can be a warning sign.
How To Use Price-To-Sales Ratios To Value Stocks
Where P/S Fall Short
That being said, total business is valuable only if, at some point, it can be translated into earnings. Consider construction companies, which have principal sales turnover, but, with the exception of building booms, make modest profits. By contrast, a software company can away generate $4 in net profit for every $10 in sales revenue. What this discrepancy means is that sellathons dollars cannot always be treated the same way for every company.
Some investors view sales revenue as a sundry reliable indicator of a company’s growth. Although earnings are not always a reliable indicator of financial health, sales receipts figures can be unreliable too.
Comparing companies’ sales on an apples-to-apples basis hardly ever works. Examination of sales necessity be coupled with a careful look at profit margins and compare the findings with other companies in the same industriousness.
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 straitened 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 in financial difficulty 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 esteem that companies with high debt levels will ultimately need higher sales to service the difficulties.
So how can investors tell the difference? There is an approach that helps to distinguish between “cheap” sales and less salubrious, debt-burdened ones: use enterprise value/sales rather than market capitalization/sales. Enterprise value files a company’s long-term debt into the process of valuing the stock. By adding the company’s
The Bottom Line
As with all valuation knacks, sales-based metrics are only part of the solution. Investors should consider multiple metrics to value a company. Low P/S can signify unrecognized value potential – so long as other criteria exist like high-profit margins, low debt au fait withs, and high growth prospects. Otherwise, the P/S can be a false indicator of value.