Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Price-to-Sales Ratio (P/S)

What it is:

The price-to-sales ratio helps determine a stock’s relative valuation. The formula to calculate the P/S ratio is:

P/S Ratio = Price Per Share / Annual Net Sales Per Share

How it works (Example):

Let's assume Company XYZ reports net sales of $5,000,000 and it currently has 500,000 shares outstanding. The stock is currently trading at $20.

Sales per Share = (5,000,000/500,000) = 10

Price-to-Sales Ratio = 20/10 = 2

Now we want to compare XYZ to one of its competitors, Company ABC.

ABC also reports net sales of $5,000,000 and it also has 500,000 shares outstanding. The stock is trading at $100.

Sales per Share = (5,000,000/500,000) = 10

Price-to-Sales Ratio = 10/10 = 10

Investors in ABC are willing to pay $10 for $1 in sales, while investors in XYZ are willing to only pay $2 for $1 in sales. Any number of scenarios could explain this discrepancy, so it's important to know what makes ABC stock so much more appealing. If you can't find a good reason, perhaps stock XYZ is undervalued, and represents a good bargain.

[Click here to read Value Traps vs. Bargains -- How to Spot the Difference]

Why it Matters:

Price-to-sales ratio is considered a relative valuation measure because it's only useful when it's compared to the P/S ratio of other firms. The P/S ratio varies dramatically by industry. For example, retail companies typically display a much higher P/S ratio than companies highly involved in research and development. Therefore, when comparing P/S ratios, make sure the firms are within the same industry.

The P/S ratio is useful because sales figures are considered to be relatively reliable. Other income statement items, like earnings, can be easily manipulated by using different accounting rules. 

Even though sales are difficult to manipulate, it's not impossible. Always read financial statements thoroughly to understand the firm's revenue recognition policy. One of Enron's accounting tricks was to recognize revenue earlier than it should have, enabling it to report inflated sales figures.

P/S is appropriate to use when valuing most types of stock. But note that P/S should never be the sole metric used when valuing a company. For example, a business may have higher sales but a lower profit margin than a competitor, indicating that it's not operating efficiently.

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