Stock prices can fluctuate due to a variety of factors, including supply and demand, economic conditions, and company performance. As a result, the current market price may not accurately reflect a stock's true value.
To determine if a stock is undervalued or overvalued, investors often use financial metrics like the price-to-sales ratio (P/S). The P/S ratio compares a company's market capitalization to its total revenue. Read this article to know more about it.
What is the Price to Sales Ratio?
The price to sales ratio (P/S ratio) is a valuation ratio that compares the total value that investors are paying for each rupee of a company's sales or revenues. It is calculated by dividing the company's market capitalisation or stock price by its sales or revenue per share over a specified period, usually 12 months. The P/S ratio is useful for comparing companies within the same industry or sector, as different industries may have different normal values for this ratio.
The P/S ratio was developed by stock market expert Kenneth L. Fisher, who 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 do not. The sales of companies remain stable and are not affected by accounting practices.
Price to sales ratio formula
The P/S ratio is calculated by dividing the company’s market capitalisation or stock price by its sales or revenue per share over a specified period, usually 12 months. The formula for calculating the P/S ratio is as follows:
P/S ratio = Market capitalisation / Sales
Alternatively, the P/S ratio can be calculated by dividing the stock price by the sales per share. The formula for this method is as follows:
P/S ratio = Stock price / Sales per Share
The sales per share can be calculated by dividing the total sales of the company by the number of outstanding shares. The sales figure can be found at the beginning of the income statement of a company.
It is important to note that while the P/S ratio is a useful tool for comparing companies within the same industry or sector, it should not be used in isolation to make investment decisions. Other factors such as earnings, cash flow, and debt levels should also be considered.
Examples of the Price-to-Sales (P/S) Ratio
Now that we have gained a solid understanding of the P/S ratio, let us delve into a real-world example to illustrate how this valuation metric works in the context of the Indian stock market. The P/S ratio can be a valuable tool for investors seeking to evaluate and compare companies within the same industry or sector.
In this example, we will use two fictional companies, company X and company Y, operating in the Indian stock market. We will calculate their respective P/S ratios to see how this metric can help investors make informed decisions.
Company X vs. Company Y
Suppose we have two companies, company X and company Y, both operating in the retail sector in the Indian stock market.
Company X:
- Market capitalisation: Rs. 1,200,000
- Total sales (revenue) over the past 12 months: Rs. 2,500,000
To calculate the P/S ratio for company X:
P/S ratio for company X = Market capitalisation / Sales
P/S ratio for company X = Rs. 1,200,000 / Rs. 2,500,000
P/S ratio for company X = 0.48
So, company X has a P/S ratio of 0.48, meaning investors are willing to pay 48 cents for every rupee of sales generated by the company.
Company Y:
- Market capitalisation: Rs. 900,000
- Total sales (revenue) over the past 12 months: Rs. 1,800,000
To calculate the P/S ratio for company Y:
P/S ratio for company Y = Market capitalisation / Sales
P/S ratio for company Y = Rs. 900,000 / Rs. 1,800,000
P/S ratio for company Y = 0.50
Company Y has a P/S ratio of 0.50, indicating that investors are willing to pay 50 cents for every rupee of sales generated by this company.
Interpreting the results
In this comparison, company X has a lower P/S ratio (0.48) compared to company Y (0.50). This suggests that investors are willing to pay a slightly lower price for each rupee of sales generated by company X, indicating that company X may be viewed as a more attractively valued investment in terms of the P/S ratio.
However, it is crucial to emphasise that the P/S ratio should not be the sole factor when making investment decisions. Other financial metrics, industry benchmarks, and qualitative factors should also be considered to gain a comprehensive understanding of a company's financial health and valuation.
In this example, even though the P/S ratios are not drastically different, they indicate subtle distinctions in how the market values these two retail companies' sales. Further analysis and due diligence would be necessary to make a well-informed investment decision, considering the broader financial context and the specific characteristics of each company.
Advantages of price to sales (P/S) ratio:
1. Simplicity
One of the most significant advantages of the P/S ratio is its simplicity. It provides a straightforward way to assess how the market values a company's sales. Investors can quickly compare companies within the same industry or sector, making it a valuable tool for initial screening.
2. Industry comparisons:
The P/S ratio is particularly useful for comparing companies within the same industry or sector. Since different industries may have distinct norms for this ratio, it helps investors assess whether a company's valuation is in line with industry standards.
3. Sales stability
Unlike earnings, which can be subject to accounting practices and manipulation, sales figures tend to be more stable and less prone to manipulation. This stability makes the P/S ratio a reliable metric for evaluating a company's financial health.
4. Early growth indicators
The P/S ratio can act as an early warning system. When a company is overvalued, as indicated by a high P/S ratio, it may signal a potential market correction. This can be beneficial for investors who want to avoid investing in companies with unrealistic valuations.
Disadvantages of price to sales (P/S) ratio:
1. Ignores profitability
The P/S ratio does not take into account a company's profitability, which is a significant drawback. Two companies with the same P/S ratio may have vastly different profit margins, making it an incomplete measure of financial performance.
2. Limited use across industries:
While the Price to Sales ratio is valuable for comparing companies within the same industry, it is less useful when comparing companies from different sectors. Industry-specific norms vary, and a low P/S ratio in one sector may not indicate the same in another.
3. Does not account for debt
The P/S ratio focuses solely on sales and market capitalisation, neglecting a company's debt levels and financial health. Companies with high debt may have different risk profiles, which the P/S ratio does not consider.
4. Short-term focus
The P/S ratio can be more relevant for companies experiencing rapid growth. It may not provide a comprehensive picture of established companies with a stable market presence.
5. Not ideal for all industries
Some companies, such as tech startups, may prioritise growth over profits in their early stages. As a result, the price sales ratio may not accurately reflect their valuation.
Price to sales ratio vs price to earnings ratio
Here is a table depicting differences between price to sales ratio and price to earnings ratio
Aspect |
Price to sales (P/S) ratio |
Price to earnings (P/E) ratio |
Calculation |
Market capitalisation / sales |
Market price per share / earnings per share |
Focus |
Sales or revenue |
Earnings or profits |
Interpretation |
How the market values a company's sales |
How the market values a company's earnings |
Use |
Suitable for evaluating revenue-related metrics, industry comparisons |
Used to assess a company's profitability and valuation |
Stability of metrics |
Sales figures tend to be stable and less prone to manipulation |
Earnings can be influenced by accounting practices and can vary significantly |
Industry comparisons |
Useful for comparing companies within the same industry or sector |
Valuable for comparing companies in different sectors |
Limitations |
Does not account for profitability, debt, or other financial aspects |
Ignores a company's revenue and may not account for growth potential |
Early warning indicator |
Can indicate overvaluation when a company's P/S ratio is very high |
May suggest overvaluation if the P/E ratio is exceptionally high |
Focus on growth companies |
More relevant for companies in early growth stages with fluctuating earnings |
Commonly used for established companies with stable earnings |
Applicability |
Appropriate for startups and companies prioritising growth over profits |
Useful for established, dividend-paying companies |
Volatility |
Typically, less volatile as sales are relatively stable |
Can be more volatile due to variations in earnings |
Conclusion
The Price to sales (P/S) ratio is a valuable metric for investors seeking a quick, industry-specific comparison of companies in the stock market. While it offers several advantages, including simplicity, and early growth indicators, it has limitations, such as its exclusion of profitability and industry-specific applicability. To make informed investment decisions, investors should use the P/S ratio with other financial metrics and consider the unique characteristics of the companies they are evaluating.
