How to Properly Use The Price to Sales (P/S) Ratio

How to Properly Use The Price to Sales (P/S) Ratio

How to Properly Use The Price to Sales (P/S) Ratio

The price to sales ratio or sometimes referred to as P/S or PS Ratio is a useful valuation metric to determine how much revenue the company makes on their top line compared to their total market capitalization.  Sometimes P/S will be also be referred to as the price to revenue ratio.

 

How the P/S Ratio is Calculated

P/S = Market Capitalization / Revenue over past 12 months

 

For example, Royal Bank of Canada (RY), the largest company on the Toronto Stock Exchange by market cap, has a market of $149 Billion as of writing and did $16.88 Billion in sales in 2018.  Therefore, RBC has a price to sales ratio of 2.47.

 

Benefits of using the P/S Ratio

The price to sales ratio can be very helpful in determining a valuation multiple for companies that do not have profitability in the last 12 months. 

 

This lack of profitability will make it have a negative PE ratio which is not helpful other than a quick understanding that the company does not have earnings.

 

The P/S ratio is also very useful for comparing a company’s valuation on a revenue basis.  It is not all telling as you still need to understand profit margins because earnings are king for long term investors.

 

If a company has a low P/S ratio, there is a lot of revenue coming into a healthy top line of the income statement.  All the company has to do is focusing on reducing costs to boost earnings.  Many famous investors such as Joel Greenblatt has performed some back testing on the market and points out that companies with low price to sales ratios have demonstrated some significant outperformance.

 

P/S ratio is favorable for many investors, including myself, because revenue is sometimes a better way to understand the true growth story of a particular company.  This is because earnings can fluctuate quite easily. 

 

However, massively fluctuating revenue or declining revenue can be an easy way to understand the trend of all cash flows entering the company on the top line.

 

Shortcomings of the P/S Ratio

Valuing a company with just P/S can be misleading.  It must be used with other valuation metrics and an understanding of profit margins to see how top line revenue will become bottom line earnings.  

 

Companies that have capital intensive business models and weak margins will often have very low attractive P/S ratios.  It is important to understand the whole story.

 

Combining the price to sales ratio with a list of other important investing metrics can be very powerful rather than a one stop shop.

 

What is considered an attractive P/S Ratio?

Price to sales ratios between 1 and 2 are generally considered attractive. 

 

While, under 1 could be a potential bargain. 

 

When you find companies with P/S ratios below 1 you can be confident that the company is generating a lot of top line revenue for the business when compared to what the market is pricing the stock.

 

Why should I care about the P/S Ratio?

The P/S ratio is one of many valuation metrics to understand very quickly how the market is pricing a particular stock.  Ensuring that you are paying a reasonable price for a stock is very important and is where many small do-it-yourself investors get burned when overvalued stocks fall quickly. 

 

For instance, many cannabis companies trade at price to sales ratios exceeding 150!  This is an insanely high number and would signal that the company is very overvalued. 

 

Not to mention, these companies are yet to turn a profit so cannot be measured on a price to earnings ratio.

 

Combining measures of growth, value and dividend income can be a very effective strategy and protects against the risk of high valued growth stocks crashing very quickly.  This is the strategy that is employed with Stratosphere Premium’s real money portfolio and has achieved some fantastic returns since inception.

 

Bottom Line

The Price to sales (P/S) ratio is a very useful valuation metric that investors should definitely pay attention to.   

The P/S ratio needs to be used in tandem with other valuation metrics and profit margins to understand the whole story. 

Low price to sales ratios have been back-tested across the market and have shown a correlation to superior stock performance. 

A low P/S will ensure that the company is generating a healthy top line of revenue which is the entry to all generation of cash for the business when compared to how the market is pricing the stock. 

 

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