Price to Sales Ratio (P/S Ratio)
Price to sales ratio definition: Price to sales, also known as sales multiple or revenue multiple, is a financial ratio calculated by dividing the total market capitalization (market cap) of a company by its annual (typically last twelve months or LTM) revenue. The ratio can be calculated on an annual or LTM basis. While calculating PSR annually, the total sales figure of the preceding financial year is used, whereas while calculating it on a LTM basis, the total sales figure of preceding four quarters is used.
Price to sales ratio calculation:
P/S ratio = Market Cap/ Revenue OR P/S ratio = stock price/ sales per share
What is price to sales ratio?
A high price to sales ratio indicates an overvalued stock and it needs to be justified by either a very high growth or presence of significant assets on the books of the company. Conversely, a low P/S ratio may indicate an attractive investment. The P/S ratio, can be used as a quick investment check, and like other valuation ratios, it makes sense to compare PSR of stocks in the same industry.
This ratio depends on the type of revenue as well. If the revenue is from buying and selling of goods, like is the case with Amazon (NASDAQ:AMZN) or Walmart (NYSE:WMT) then the P/S ratio tends to be low. However if the revenue is from say a service or from commissions, like Google (NASDAQ:GOOG) or eBay (NASDAQ:EBAY) then the price to sales ratio for such companies tends to be higher.
Price to Sales ratio pitfalls
- The price to sales ratio does not take into account a company's debt. Companies that are on the verge of bankruptcy can also have a low price to sales ratio, as in such cases the share price drops drastically but the same might not have affected the revenues.
- A company might be generating high revenues, but the same might not be translating to profitability for the company. In such cases also an investor will see a low price to sales ratio, but a company which does not growing its profits will eventually turn out to be a bad investment.
- Even though sales figures are difficult to manipulate, it's not totally impossible. There is immense pressure on the top management of every company to report continuously rising revenue. A good example of this is Enron which reported inflated revenues. An investor would do well to read the entire financial statement.
Price to Sales ratio of tech stocks
Price to sales ratio as a valuation metric got prominence due to internet stocks. Most of them did not have much in the name of profitability at the time of their IPO, and hence price to earnings would not hold much of a meaning for such stocks. Take the example of Twitter (NYSE:TWTR), which had its IPO in 2013. Economist Max Wolff had quoted "A tech IPO like Twitter with no profit is an emotional event, not a fundamental event. You either believe or you don't.
Figure 1: TWTR P/S ratio Vs FB P/S ratio Vs GOOGL P/S ratio
The chart in figure 1, shows the price to sales ratio comparison of Twitter stock Vs Facebook stock Vs Google stock. The industry average price to sales ratio for internet stocks is around 7x. Internet stock Twitter (See: Twitter stock analysis) is way above this average at 26x (as of July, 2014), while Facebook (See: Facebook stock analysis) which has a much larger user base has a price to sales ratio of 17x. Tech stock Google (See: Google stock analysis) with strong business fundamentals has a P/S ratio of only 6x. Hence apart from the P/S ratio, it is important to consider other fundamentals while making an investment.
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