We are going to run through a few valuation multiples in the next few posts that are used to compare different companies, and the different strengths and weaknesses of each multiple for analysing companies. The ratios we will look at are the P/E, P/B, P/Sales, PEG and EV/EBITDA ratios. The next ratio up is the Price to Sales Ratio.
The Price to Sales Ratio is the ratio of the price per share of a company versus the $ sales per share of the company. The Price to Sales ratio is a less commonly used ratio than Price to Book or Price to Earnings, however it can be a very useful analytical tool as well. The calculation of the P/S ratio is quite simple. If a share in a company is trading at $5.00, and that company had $100 in sales and 30 shares outstanding, then the Price to Sales ratio is equal to ($5.00 x 30)/$100 = $150/100 = 1.5x
The strengths of the Price to Sales Ratio include:
- The Sales level of a company is generally much more stable than the earnings level of a company, so any large changes in the P/S ratio are often more likely to indicate a departure from the intrinsic value of the company (either upwards or downwards);
- For cyclical companies in particular, they will often average a certain return on equity through the cycle, but can have steep departures either above or below their average ROE depending on the point in the business cycle. As such the P/S ratio can provide a better indication of the relative value than the P/E ratio as it ignores temporary fluctuations in profit levels;
- Sales is the back-bone to profits - if you have no sales you have no profits. A company can generally find ways to generate an accounting profit by cutting costs or selling assets, so often the sales level and P/S ratio will be a better indicator of the financial health of your investment in the company;
Some weaknesses of the Price to Sales ratio include:
- It has no direct linkage to profits or cash flow, so it rarely if ever indicates whether the company is able to generate either a profit, or cash, both of which are required to provide shareholders with a return over the long run;
- It is not very comparable across industries, as some industries are able to generate substantially higher net profit margins than others, which inevitably will justify higher price to sales ratios as well;
- It does not take into account the capital structure of the company. If a company has huge debt levels this does not get reported directly or indirectly in any way by the price to sales ratio.