Fundamental Investment 101 – Price/Sales
This is part of a series of very basic fundamental investment principles. I will try to explain in no-nonsense terms the simplest concepts of fundamental investing and how to apply them when researching stocks.
This series includes the most necessary information for comparative valuation – it is not a financial analysis guide and will try to keep things as simple as possible.
What is the Price / Sales Ratio?
Price/Sales or P/S is the most widely used valuation metric for stocks (equities). The ratio expresses a company’s share price divided by the company’s sales or revenue per share.
Revenue per share itself is not a widely used metric, and it is calculated by dividing the total sales or turnover of a company by the number of outstanding shares.
If ACME Corp. generated a turnover of $10bn last year and they have 200mn shares outstanding, the turnover per share is 10,000,000,000 / 200,000,000 = $50
If one share of ACME Corp is trading at $75 the P/S of ACME Corp. is $ 75 / $50 = 1.5 (or 1.5-times or 1.5x).
The ratio is thus a multiple of the company’s turnover attributable to each shareholder (or share to be precise).
It also means that if ACME Corp is going to generate the same top line or revenue for the next consecutive 1 1/2 years, the company’s sales per share will have surpassed the purchase price of a single share.
Why is the P/S ratio important?
Price / Sales is the most basic valuation metric to compare companies of any shape and form, even when they are loss-making or have different accounting standards.
It is kind of the lowest common denominator to look at companies across different stages of maturity, countries, industries, and profitability.
Nearly every stock market listed company generates revenue even when they are research companies, early-stage companies, or not profitable.
Many companies in the software start-up space are primarily valued on price sales (or revenue multiple) and growth rates, and in VC-speak, recurring subscription sales over the period of one year would be termed as ARR (annual recurring revenue).
Hence, Price-to-Sales is a valuable tool of filtering for attractive companies.
One can say a low P/S indicates a cheap (or attractive) company, and a high P/S indicates an expensive (or unattractive) company.
Again, this is not necessarily true in every case. For example, companies growing rapidly are valued at a higher price-to-sales ratio because they will generate more turnover in the future years than today.
On the reverse, companies with extremely thin margins such as trading companies, consumer stores, supermarkets, or businesses in production intensive industries such as mining, industry, chemicals, etc. can look attractive on a price-to-sales basis, yet out of a lot of sales, there is nearly no profit made (or even losses).
It is important not to look at the price-sales ratio in an isolated manner but also consider industry, peer-group, and expected growth rate and look at a company in a relative-value way.
Historic Price/Earnings (PS) or Trailing P/S ratio
The price-sales ratio is based on the previous financial year’s turnover and current share price. Sometimes this is also referred to as TTM (trailing-twelve-months).
Forward Price/Earnings (PSe) or expected Price/Sales
The price-sales ratio is based on the current financial year’s expected turnover (usually based on the median estimate by wall-street analysts) and the current share price.
The forward price/sales ratio includes the expected sales growth for the current financial year and is thus usually preferred over the historic P/S.
Price-Sales limitations
In general, price-to-sales ratios are primarily used to compare growth companies that generate little profit (or are loss-making) and display high growth.
Also, the companies one compares should have a relatively similar balance sheet structure: lean and clean (not a lot of debt, goodwill, etc.).
Applying price-to-sales ratios is much more challenging when comparing heavily indebted companies, loss-making, or having some more complex activity going on beneath the top line.
Insofar, suitable to use to compare within the same industry, in a lean-balance sheet industry, and if there are no better ways to compare (e.g., loss-making). Software and tech companies are good examples.
Further reading
For more in-depth details on the P/E, I can recommend taking a look at the Investopedia article and the Motley Fool page.
