Investors today are equipped with numerous tools and methods which reduce the chances of making an ill-informed decision. One such tool is Price to Sales ratio (P/S ratio) which helps an investor understand whether a company’s share is worth buying.
While this tool does not give the complete picture of a company’s performance, it provides useful insights when used along with other financial ratios.
In this article, we will understand the Price to Sales ratio in depth, how it is calculated, its potential advantages and disadvantages and why it may be important for investors.
Understanding price to sales ratio
The Price to Sales ratio, popularly known as P/S ratio, is a financial tool that compares a company’s market value with its revenue.
In simple terms, it shows how much investors are willing to pay for each unit of sales a company generates. A lower ratio may suggest that the stock is relatively less expensive compared to its sales, while a higher ratio may indicate that investors are paying more for the same amount of sales.
This ratio is especially helpful in industries where companies may not be profitable yet but are growing rapidly in terms of sales.
Read Also: Price-to-Earnings (P/E) Ratio: Meaning, Benefits, Formula and Calculation
Origin of the price to sales ratio
The Price to Sales ratio was introduced by stock market expert Kenneth L. Fisher. He observed that during early growth phases, investors often overvalue companies and when results don’t meet expectations, they panic and sell. Fisher believed that companies with capable management can identify problems, fix them and continue to grow, eventually leading to a rise in earnings and share prices.
To address over-valuation, he developed the P/S ratio. Unlike earnings, which can fluctuate and be influenced by accounting methods, sales remain relatively steady, making them a more reliable base for valuing a company.
Breaking down the price to sales ratio
The Price to Sales (P/S) ratio is one of the simplest ways to judge a company’s valuation, as it shows how much investors are willing to pay for each unit of a company’s sales. Since the main goal of any business is to generate sales, this ratio reflects value based on real operations without being influenced by accounting adjustments.
It is especially useful for valuing start-ups or companies with little or no profit. A low P/S ratio may often signal undervaluation, but it is advised to be compared with industry trends and past data. Investors should also study other factors, since no single ratio tells the full story.
Read Also: Information Ratio - Meaning, Formula, and Calculation
How to calculate P/S ratio?
The calculation of the Price to Sales ratio is simple. It involves dividing the company’s market capitalisation by its total sales, i.e., its revenue.
Market capitalisation refers to the stock price multiplied by the number of outstanding shares.
Sales refer to the total income generated by the company in a financial year.
The sales value can be found on a company’s income statement and the number of outstanding shares is also listed there or in the notes section. The sales figure used in the formula can be taken from different time periods.
Investors may calculate this ratio using either:
- Trailing sales: Sales from the last 12 months (historical data).
- Forward sales: Projected sales for the upcoming 12 months (future estimates).
Like most financial ratios, the P/S ratio can change daily, so it is important to note the time of calculation. It does not show the company’s exact value but gives an estimate for comparison with industry peers.
Formula for the price to sales ratio
The formula for the Price to Sales (P/S) ratio is simple.
P/S ratio = MVS / SPS
where:
MVS = Market Value per Share
SPS = Sales per Share
Numerical example
To understand P/S ratio calculation better, let’s suppose a company named ABC has following details:
Current share price: Rs. 200
Outstanding shares: 10 lakh
Total sales (Revenue): Rs. 50 crore
Step 1: Calculate market capitalisation
Market cap = 200 × 10,00,000 = 20,00,00,000 = Rs. 20 crore
Step 2: Apply the formula
MVS / SPS = 20 crore / 50 crore
P/S Ratio = 0.4
This means investors are paying 40 paise for every Rs. 1 of sales the company generates.
*Example for illustrative purpose only.
Advantages of price to sales (P/S) ratio
The Price to Sales (P/S) ratio, also called the sales multiple or revenue multiple, is an important tool for valuing companies. It shows how much investors are willing to pay for every rupee of a company’s sales.
The ratio can be calculated in two ways: by dividing a company’s market value (market capitalisation) by its total sales over the past 12 months or by dividing the stock price by sales per share. This ratio is most useful when comparing companies in the same industry.
A low P/S ratio may suggest undervaluation, while a very high ratio could point to overvaluation.
Read Also: Leverage Ratio: Definition, Formula and Calculation
Limitations of the price to sales ratio
The P/S ratio does not show whether a company is making profits or if it will generate profits in the future. It can also be tricky to compare companies from different industries.
For example, a video game company and a grocery store may both have sales, but their ability to turn those sales into profit is very different. Another limitation is that the P/S ratio ignores a company’s debt and overall financial health shown in the balance sheet.
Conclusion
The Price to Sales ratio is a simple and widely used measure to understand how much investors are paying for a company’s sales. While it provides useful insights, it is recommended to not be used as the only tool for evaluating a stock.
FAQs
Why is the Price to Sales (P/S) ratio useful to investors?
The P/S ratio is useful because it shows how much investors are paying for each unit of sales. It helps in understanding valuation, especially when earnings are volatile.
What does a low P/S ratio mean?
A low P/S ratio may indicate that the stock is relatively less expensive compared to its sales. However, it does not always mean the stock is favourable, as other factors like profitability and debt must also be considered.
What is the difference between the P/S ratio and the P/E ratio?
The P/S ratio compares price with sales, while the P/E ratio compares price with earnings (profit).
What is a good Price to Sales ratio?
There is no universal answer. What may be suitable in one industry may not be suitable in another. Rapidly growing tech firms may have higher P/S ratios. Mature, low-growth potential sectors like manufacturing or retail may have lower acceptable ranges.
What is a justified Price to Sales ratio?
A justified P/S ratio refers to the ratio that reflects both the company’s current sales and its potential growth. It is often calculated using forward-looking projections, but estimates may vary.
Why is the Price to Sales ratio important for evaluating a company’s stock?
It is important because it provides a simple way to understand how the market values a company in relation to its sales.
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This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.
The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed.The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.
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