The Price to Sales ratio, also known as the P/S ratio, is a formula used to measure the total value that investors place on the company in comparison to the total revenue generated by the business. It is calculated by dividing the share price by the sales per share.
Origin of the Price to Sales Ratio
The P/S ratio was developed by stock market expert Kenneth L. Fisher. Fisher noticed that when a company experiences a period of early growth, investors place an unrealistic valuation on the company. When the value of the company drops below their expectations, the investors panic and sell the stock.
Fisher believed that a company with strong management should be able to identify, solve the problems and move on. If they can address the situation, the company’s share price and earnings will rise.
To help solve the problem of over-valuation, Fisher came up with the P/S ratio. The value of the sales is used as the base for the formula because while earnings fluctuate, sales don’t. The sales of companies remain stable and are not affected by accounting practices.
Breaking Down the Price to Sales Ratio
The price to sales ratio is one of the easiest ways to understand the valuation of a company, as it helps investors know how much they are truly paying for the company. The main operation in any business is to generate revenue from the sale of goods and services, and the P/S ratio provides the valuation based on the operations of the company without any accounting adjustments.
The P/S ratio also helps new companies or startups with zero net income place a valuation on their assets. A low P/S ratio is considered optimal as it indicates that the company is undervalued, but nonetheless, the ratio needs to be looked at from a historical and industry point of view as well.
An investment opportunity should be looked at from all aspects of the company, which can help identify an underlying issue that cannot be found by looking at the results of each formula individually.
Formula for the Price to Sales Ratio
The formula for the price to sales ratio is:
The total sales value can be found on the income statement, while the total number of shares outstanding is also available on the income statement or in the notes section of the same document. The sales figure in the formula can be from either of the following time periods:
Similar to most financial metrics, the value of the price to earnings ratio can change every day, hence it is important that the valuation is time stamped. The P/S ratio is not the actual valuation of the company but is the expected valuation that is then used to understand the true valuation and compared to the valuation of other companies in the same industry.
The table above indicates the share price and the sales per share for a toy company. The price to earnings ratio is calculated as well (10/8 = 1.25). The company’s share price increased by 50% over three years while the sales per share rose at a slower pace. It essentially means that the investors are paying more for the shares now than they were three years ago.
When we look at the P/S ratio, we can see that in Year 1, investors were paying $1.25 per share and in Year 3, they were paying $1.50 for the same share. Several factors can contribute to an increase in the P/S ratio. It can be due to trends in the market, investor speculation, or an increase in the company’s market share.
Limitations of the Price to Sales Ratio
The price to earnings ratio comes with its limitations. For example, the P/S ratio is different across many industries, and it is often hard to compare companies in various sectors. The ratio cannot differentiate a leveraged company from an unleveraged one as a company can report a low P/S ratio and can be close to bankruptcy.
Also, the P/S ratio does not provide any information on the profitability or costs of the company; hence, it is important for investors to look at the P/S ratio along with other financial ratios and not just individually.
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