In one of our earlier articles, we have discussed the price to earnings ratio, which is popularly known as P/E ratio or P/E multiple. In this article, we will tell you how to calculate price to sales ratio, and whether it is considered as the king of the value factors.
The price to sales ratio is used as a profitability analysis tool to discover undervalued and overvalued securities. It’s also referred to as PSR or P/S ratio.
Price to sales ratio is similar to price to earnings ratio (P/E), but measures the price of the company against annual sales instead of net earnings or net profits. This means P/S Ratio measures a company’s value, in terms of its stock’s current market price, in relation to its annual sales or revenue.
Price to sales ratio is also referred to as sales multiple or revenue multiple, because it shows the price that investors are willing to pay on company’s sales.
Mathematical formula to calculate P/S ratio = Market price per share / Sales per share
Or
Price to sales ratio = market capitalization / total sales or revenue
You can find a company’s share price from stock exchanges like NSE, BSE, NASDAQ, NYSE etc.
Sale per share is calculated by dividing the company’s total revenue by the number of shares outstanding. Both revenue and total number of outstanding shares can be obtained from the company’s financial statements.
Market capitalisation is calculated by multiplying the number of outstanding shares with the current market price of the stock.
Example: How to calculate price to sales ratio
Let us assume company XYZ limited’s market share price as on 09/07/2023 is 1,000 rupees.
As per the financial statements, the company XYZ limited’s outstanding shares are 1,00,000 and annual revenue is Rs 2,00,00,000.
To calculate P/S ratio, we have to first find out sales per share. To calculate it, we have to divide the company’s revenue by outstanding shares.
Sale per share = Rs 2,00,00,000 / 1,00,000 = Rs 200
The price to sales ratio of XYZ limited = Market price per share / Sales per share = 1,000 / 200 = Rs 5
What Price to sales ratio (P/S) tells you
After knowing how to calculate the price to sales ratio, the following questions arises;
Is a higher price to sales ratio better?.
Should you invest in a low price to sales ratio stock?
Sales is the lifeblood of the company. Ability to generate higher revenue is a strong indicator of what a company is really worth.
As discussed above a price to sales ratio is a revenue multiple. This means it tells you how much the market is willing to pay on a company’s ability to generate revenue.
In other words, it tells you how much you need to pay to buy one share of the company relative to how much that company generated in revenue per share.
In our above example, the price to sales ratio of 5 tells you that the company’s shareholders are willing to pay 5 times the company’s ability to generate sales per share.
P/S ratio summarizes in a single number the market price measured against revenue or sales.
A price to sales ratio of 1 means that investors are paying Rs. 1 for every Rs. 1 of revenues the company generates.
An increase in price to sales ratio suggests that investors are willing to pay a premium on a company’s sales.
In our above example, if P/S ratio is 2, then it means the market is paying Rs. 2 for every Rs. 1 of revenues the company generates.
Therefore, a higher price to sales ratio indicates that investors are spending more to gain a return on investment. A higher price to sales ratio indicates that the company is overvalued.
Decrease in P/S ratio suggests that investors discounted the company’s revenue. For instance, instead of 1, if P/S ratio is less than Rs. 1, then it means the market is paying less than Rs. 1 to earn Rs. 1.
Many value investors consider buying low price to sales ratio stocks as they believe they are getting a bargain.
Low price to sales ratio indicates that the stock is undervalued. It signals that the company is performing well but the market has undervalued the stock. In such cases, there are chances the stock may outperform the general stock market.
Remember, overvaluation or undervaluation based on price to sales ratio should not be the only factor for investment.
Companies with low P/S ratio can end up bankrupt due to high debt or other factors. Similarly the higher the P/S ratio, the bigger is the risk as you are buying at a higher price.
Value investors compare the P/S ratio of different companies within the same sector to find out whether the stock is undervalued or overvalued in relation to its peers.
Limitations of Price to sales ratio
Price to sales ratio fails to take into account the capital that might have been sourced from debt as it only takes into account capital that comes from equity (price per share).
Another limitation of Price to sales ratio is its not considering expenses. A company’s revenue can not be negative but net profit which is calculated after deducting total expenses from total revenue can be negative.
For instance a construction company which might have high sales but modest profits and high debts in the balance sheet. In comparison a software company may not have high debt and expenses to generate earnings. Similarly a grocery store or retail industry has massive amounts of sales but relatively low profit margin.
Price to sales (P/S) ratio will be most useful while comparing similar companies within similar industries against each other as different entities and different sectors have varying capital requirements.
The Price to sales (P/S) ratio is also useful when analyzing companies with similar financing structures especially considering companies that do not carry debt.
A company with no debt and a low P/S multiple is a more attractive investment in comparison to a company with high debt and the same P/S ratio. A high debt company needs higher sales to service the cost of debt i.e. interest.
You should not base your decision on a single ratio or indicator. Like any other financial ratio, the P/S ratio should be put into context with additional fundamental tools.
You can use following ratios in addition to price to sales ratio for better understanding of company’s financial position;
- Price-to-book-value ratio (P/B ratio): measures stock price against the net assets (total assets minus total liabilities).
- Enterprise value-to-sales ratio (EV/sales ratio): divides enterprise value (Market capitalization + Total Debts – Cash) by company sales.
- Price to earnings ratio (P/E ratio): measures stock price against the net earnings.
- Price-to-cash-flow ratio: measures stock price against the operating cash flow of a company.
