how to use price-to-sales ratios to value stocks

8/13/2019 How to Use Price-To-Sales Ratios to Value Stocks

1/3

w To Use Price-To-Sales Ratios To Value Stocks

//www.investopedia.com/articles/fundamental/03/032603.asp[02-Oct-13 12:44:53 AM]

How To Use Price-To-Sales Ratios To Value Stocks

February 26 2013| Filed Under Fundamental Analysis, P/S, Sector - Consumer Cyclical,Value

Investing

Investors are always seeking ways to compare the value of stocks. The price-to-sales ratio

(Price/Sales or P/S) provides a simple approach: take the company's market capitalization(the

number of shares multiplied by the share price) and divide it by the company's total sales over the

past 12 months. The lower the ratio, the more attractive the investment. As easy as it sounds, price-

to-sales provides a useful measure for sizing up stocks. But investors need to be mindful of the

ratio's potential pitfalls and possible unreliability.

SEE: Financial Ratio

How P/S Is Useful

In a nutshell, this ratio shows how much Wall Street values every dollar of the company's sales.

Coupled with high relative strength in the previous 12 months, a low price-to-sales ratio is one of

the most potent combinations of investment criteria. A low P/S can also be effective in valuing

growth stocksthat have suffered a temporary setback.

In a highly cyclical industrysuch as semiconductors, there are years when only a few companies

produce any earnings. This does not mean semiconductor stocks are worthless. In this case,

investors can use price-to-sales instead of the price-earnings ratio(P/E Ratio or PE) to determine

how much they are paying for a dollar of the company's sales rather than a dollar of its earnings.

P/S is used for spotting recovery situations or for double checking that a company's growth has not

become overvalued. It comes in handy when a company begins to suffer losses and, as a result, has

no earnings (and no PE) with which investors can assess the shares.

Let's consider how we evaluate a firm that has not made any money in the past year. Unless the

firm is going out of business, the P/S will show whether the firm's shares are valued at a discount

against others in its sector. Say the company has a P/S of 0.7 while its peers have higher ratios of,

say, 2. If the company can turn things around, its shares will enjoy substantial upside as the P/S

becomes more closely matched with those of its peers. Meanwhile, a company that goes into a loss

(negative earnings) may lose also its dividend yield. In this case, P/S represents one of the last

remaining measures for valuing the business. All things being equal, a low P/S is good news for

investors, while a very high P/S can be a warning sign.

Where P/S Fall Short

That being said, turnoveris valuable only if, at some point, it can be translated into earnings.

Consider construction companies. They report very high sales turnover, but, with the exception of

building booms, they rarely make much in the way of profit. By contrast, a software company can

easily generate $4 in net profit for every $10 in sales revenue. What this discrepancy means is that

sales dollars cannot always be treated the same way for every company.

Many people look at sales revenue as a more reliable indicator of a company's growth. Granted,

earningsare a complicated bottom-linenumber, whose reliability is not always assured. But, thanks

to somewhat hazy accounting rules, the quality of sales revenue figures can be unreliable too.

Comparing companies' sales on an apples-to-apples basis hardly ever works. Examination of sales

must be coupled with a careful look at profit marginsand their trends, as well as with sector-specific

margin idiosyncrasies.

Follow Us:

Marketplace

Related Articles

Investing In Healthcare Facilities

Analyzing An AcquisitionAnnouncement

Yield Investing: Dividend, EarningsAnd FCF

Warren Buffett: How He Does It

Equity Valuation: The ComparablesApproach

Trading Center

Partner Links

Sign In Register Free Annual Reports Free Tools

Analysis & Opinions ETF Center Sectors Chart Advisor Free Tools Free Annual Reports

Dictionary Investing Markets Personal Finance Active Trading Forex Professionals Tutorials Video Simulator Free Newsletters

Search InvestopediaSearch
http://www.investopedia.com/tags/fundamental_analysis/http://www.investopedia.com/tags/p-s/http://www.investopedia.com/tags/sector_-_consumer_cyclical/http://www.investopedia.com/tags/sector_-_consumer_cyclical/http://www.investopedia.com/tags/value_investing/http://www.investopedia.com/tags/value_investing/http://www.investopedia.com/terms/p/price-to-salesratio.asphttp://www.investopedia.com/terms/m/marketcapitalization.asphttp://www.investopedia.com/university/ratios/http://www.investopedia.com/terms/g/growthstock.asphttp://www.investopedia.com/articles/02/102202.asphttp://www.investopedia.com/terms/p/price-earningsratio.asphttp://www.investopedia.com/terms/d/dividendyield.asphttp://www.investopedia.com/terms/t/turnover.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/articles/fundamental/04/042804.asphttp://www.facebook.com/Investopediahttp://www.investopedia.com/articles/investing/093013/investing-healthcare-facilities.asphttp://www.investopedia.com/articles/stocks/08/acquisition-announcement.asphttp://www.investopedia.com/articles/stocks/08/acquisition-announcement.asphttp://www.investopedia.com/articles/investing/090913/yield-investing-dividend-earnings-and-fcf.asphttp://www.investopedia.com/articles/investing/090913/yield-investing-dividend-earnings-and-fcf.asphttp://www.investopedia.com/articles/01/071801.asphttp://www.investopedia.com/articles/investing/080913/equity-valuation-comparables-approach.asphttp://www.investopedia.com/articles/investing/080913/equity-valuation-comparables-approach.asphttp://www.investopedia.com/accounts/login.aspx?returnurl=http%3A%2F%2Fwww.investopedia.com%2Farticles%2Ffundamental%2F03%2F032603.asphttp://www.investopedia.com/accounts/signupmember/?returnurl=http%3A%2F%2Fwww.investopedia.com%2Farticles%2Ffundamental%2F03%2F032603.asphttp://investopedia.ar.wilink.com/http://www.investopedia.com/freehttp://www.investopedia.com/markets/stock-analysis/http://www.investopedia.com/markets/etfs/http://www.investopedia.com/markets/sectors/http://www.investopedia.com/active-trading/chartadvisor/http://www.investopedia.com/free/http://investopedia.ar.wilink.com/http://www.investopedia.com/dictionary/http://www.investopedia.com/investing/http://www.investopedia.com/markets/http://www.investopedia.com/markets/http://www.investopedia.com/personal-finance/http://www.investopedia.com/active-trading/http://www.investopedia.com/forex/http://www.investopedia.com/professionals/http://www.investopedia.com/university/http://www.investopedia.com/video/http://www.investopedia.com/simulatorhttp://www.investopedia.com/accounts/signupnewsletter/?returnurl=http://www.investopedia.com/default.aspxhttp://www.investopedia.com/accounts/signupnewsletter/?returnurl=http://www.investopedia.com/default.aspxhttp://www.investopedia.com/simulatorhttp://www.investopedia.com/video/http://www.investopedia.com/university/http://www.investopedia.com/professionals/http://www.investopedia.com/forex/http://www.investopedia.com/active-trading/http://www.investopedia.com/personal-finance/http://www.investopedia.com/markets/http://www.investopedia.com/markets/http://www.investopedia.com/investing/http://www.investopedia.com/dictionary/http://investopedia.ar.wilink.com/http://investopedia.ar.wilink.com/http://www.investopedia.com/free/http://www.investopedia.com/active-trading/chartadvisor/http://www.investopedia.com/markets/sectors/http://www.investopedia.com/markets/etfs/http://www.investopedia.com/markets/stock-analysis/http://www.investopedia.com/freehttp://investopedia.ar.wilink.com/http://www.investopedia.com/accounts/signupmember/?returnurl=http%3A%2F%2Fwww.investopedia.com%2Farticles%2Ffundamental%2F03%2F032603.asphttp://www.investopedia.com/accounts/login.aspx?returnurl=http%3A%2F%2Fwww.investopedia.com%2Farticles%2Ffundamental%2F03%2F032603.asphttp://www.investopedia.com/http://www.investopedia.com/http://www.investopedia.com/articles/investing/080913/equity-valuation-comparables-approach.asphttp://www.investopedia.com/articles/investing/080913/equity-valuation-comparables-approach.asphttp://www.investopedia.com/articles/01/071801.asphttp://www.investopedia.com/articles/investing/090913/yield-investing-dividend-earnings-and-fcf.asphttp://www.investopedia.com/articles/investing/090913/yield-investing-dividend-earnings-and-fcf.asphttp://www.investopedia.com/articles/stocks/08/acquisition-announcement.asphttp://www.investopedia.com/articles/stocks/08/acquisition-announcement.asphttp://www.investopedia.com/articles/investing/093013/investing-healthcare-facilities.asphttp://www.investopedia.com/flipboard.aspxhttp://www.investopedia.com/rss/http://www.investopedia.com/rss/https://plus.google.com/117058237613563836556/postshttps://plus.google.com/117058237613563836556/postshttp://twitter.com/#%21/investopediahttp://twitter.com/#%21/investopediahttp://www.facebook.com/Investopediahttp://www.facebook.com/Investopediahttp://www.investopedia.com/articles/investing/080913/equity-valuation-comparables-approach.asphttp://www.investopedia.com/articles/01/071801.asphttp://www.investopedia.com/articles/investing/090913/yield-investing-dividend-earnings-and-fcf.asphttp://www.investopedia.com/articles/stocks/08/acquisition-announcement.asphttp://www.investopedia.com/articles/investing/093013/investing-healthcare-facilities.asphttp://www.investopedia.com/articles/fundamental/04/042804.asphttp://www.investopedia.com/terms/b/bottomline.asphttp://www.investopedia.com/terms/e/earnings.asphttp://www.investopedia.com/terms/t/turnover.asphttp://www.investopedia.com/terms/d/dividendyield.asphttp://www.investopedia.com/terms/p/price-earningsratio.asphttp://www.investopedia.com/articles/02/102202.asphttp://www.investopedia.com/terms/g/growthstock.asphttp://www.investopedia.com/university/ratios/http://www.investopedia.com/terms/m/marketcapitalization.asphttp://www.investopedia.com/terms/p/price-to-salesratio.asphttp://www.investopedia.com/tags/value_investing/http://www.investopedia.com/tags/value_investing/http://www.investopedia.com/tags/sector_-_consumer_cyclical/http://www.investopedia.com/tags/p-s/http://www.investopedia.com/tags/fundamental_analysis/


2/3



Ben McClure is a long-time contributor to Investopedia.com. A specialist in preparing early stagetechnology ventures for investment and the marketplace, Ben manages the Business Incubator at theUniversity of Malta. Ben was a highly-rated European equities analyst at London-based Old MutualSecurities, and led new venture development at TEC Edmonton, a major technology commercializationconsulting group in Canada.

Debt Is a Critical Factor

A firm with no debt and a low P/S metric is a more attractive investment than a firm with high debt

and the same P/S. At some point, the debt will need to be paid off, so there is always the possibility

that the company will issue additional equity. These new shares expand market capitalization and

drive up the P/S.

Companies heavy with corporate debtand on the verge of bankruptcy, however, can emerge with

low P/S. This is because their sales have not suffered a drop while their share price and

capitalization collapses.

So how can investors tell the difference? There is an approach that helps to distinguish between

"cheap" sales and less healthy, debt-burdened ones: use enterprise value/sales rather than marketcapitalization/sales. By adding the company's long-term debt to the company's market capitalization

and subtracting any cash, one arrives at the company's enterprise value (EV).

Think of EV as the total cost of buying the company, including its debt and leftover cash, which

would offset the cost. EV shows how much more investors pay for the debt. This approach also helps

eliminate the problem of comparing two very different types of companies:

1. The kind that relies on debt to enhance sales and

2. The kind that has lower sales but does not shoulder debt.

The Bottom Line

As with all valuation techniques, sales-based metrics are just the beginning. The worst thing that an

investor can do is buy stocks without looking at underlying fundamentals. Low P/S can indicateunrecognized value potential - so long as other criteria like high profit margins, low debt levels and

growth prospects are in place. In other cases, P/S can be a classic value trap.

Try Our Stock Simulator!Test your trading skills!

Sign Up For Our Stock Watch WeeklyNewsletter!

by Ben McClure

comments powered by Disqus

Disqus seems to be taking longer than usual. Reload?

Dictionary Investing Markets Personal Finance Active Trading Forex Professionals Tutorials Video Simulator Free Tools

Sign Up!
http://www.investopedia.com/articles/basics/03/091903.asphttp://www.investopedia.com/terms/e/enterprisevalue.asphttp://www.investopedia.com/terms/v/valuetrap.asphttp://www.investopedia.com/terms/v/valuetrap.asphttp://www.investopedia.com/simulator?utm_source=markets:&utm_medium=website&utm_campaign=simpromolinkhttp://www.investopedia.com/contributors/49http://disqus.com/http://www.investopedia.com/dictionary/http://www.investopedia.com/investing/http://www.investopedia.com/markets/http://www.investopedia.com/personal-finance/http://www.investopedia.com/active-trading/http://www.investopedia.com/forex/http://www.investopedia.com/professionals/http://www.investopedia.com/university/http://www.investopedia.com/video/http://www.investopedia.com/simulatorhttp://www.investopedia.com/free/http://www.investopedia.com/free/http://www.investopedia.com/simulatorhttp://www.investopedia.com/video/http://www.investopedia.com/university/http://www.investopedia.com/professionals/http://www.investopedia.com/forex/http://www.investopedia.com/active-trading/http://www.investopedia.com/personal-finance/http://www.investopedia.com/markets/http://www.investopedia.com/investing/http://www.investopedia.com/dictionary/http://disqus.com/http://disqus.com/http://www.investopedia.com/contributors/49http://www.investopedia.com/simulator?utm_source=markets:&utm_medium=website&utm_campaign=simpromolinkhttp://www.investopedia.com/terms/v/valuetrap.asphttp://www.investopedia.com/terms/e/enterprisevalue.asphttp://www.investopedia.com/articles/basics/03/091903.asphttp://www.investopedia.com/contributors/49


3/3



Content Library

Articles

Tutorials

Slideshows

FAQs

Calculators

Chart Advisor

StockAnalysis

Work With Investopedia

License Our Dictionary

Advertise With Us

Email Campaign Deployment

About Our Writers

Write For Us

Contact Us

Careers

Sponsors & Partners

Free Annual Reports

CanDoFinance

Newsletters

Sign up for our FREE e-Newsletters

2013, Investopedia US, A Division of ValueClick, Inc.

All Rights Reserved| Terms Of Use| Privacy Policy
http://www.investopedia.com/articles/http://www.investopedia.com/university/http://www.investopedia.com/slide-show/http://www.investopedia.com/ask/http://www.investopedia.com/calculator/http://www.investopedia.com/active-trading/chartadvisor/http://www.investopedia.com/markets/stock-analysis/http://www.investopedia.com/licensing/Dictionary.aspxhttp://www.investopedia.com/corp/advertise.asphttp://www.investopedia.com/EmailCampaign.aspxhttp://www.investopedia.com/corp/writers/http://www.investopedia.com/WriteForUs.aspxhttp://www.investopedia.com/contact.aspxhttp://www.investopedia.com/careers/http://investopedia.ar.wilink.com/http://www.candofinance.com/http://www.investopedia.com/accounts/signupnewsletter/?list=TOD_Charthttp://www.investopedia.com/corp/copyright.aspxhttp://www.investopedia.com/corp/termsofuse.aspxhttp://www.investopedia.com/corp/privacypolicy.aspxhttp://www.investopedia.com/corp/privacypolicy.aspxhttp://www.investopedia.com/corp/termsofuse.aspxhttp://www.investopedia.com/corp/copyright.aspxhttp://www.investopedia.com/accounts/signupnewsletter/?list=TOD_Charthttp://www.candofinance.com/http://investopedia.ar.wilink.com/http://investopedia.ar.wilink.com/http://www.investopedia.com/careers/http://www.investopedia.com/contact.aspxhttp://www.investopedia.com/WriteForUs.aspxhttp://www.investopedia.com/corp/writers/http://www.investopedia.com/EmailCampaign.aspxhttp://www.investopedia.com/corp/advertise.asphttp://www.investopedia.com/licensing/Dictionary.aspxhttp://www.investopedia.com/markets/stock-analysis/http://www.investopedia.com/active-trading/chartadvisor/http://www.investopedia.com/calculator/http://www.investopedia.com/ask/http://www.investopedia.com/slide-show/http://www.investopedia.com/university/http://www.investopedia.com/articles/

how to use price-to-sales ratios to value stocks

Documents