What do you understand the Price to Sales ratio?
The Price to sales ratio is a price multiple ratios that measure the price for an investor to invest in a stock of a company by observing its related revenue.
In a short firm, it is also called the P/S ratio or PSR. This ratio is a computed year to year basis, usually, twelve months, that is why is it also called the revenue multiple.
The price-to-sales (P/S) ratio is a kind of valuation ratio or price multiple ratios that compare a company’s stock price to its revenues.
The P/S ratio is calculated to divide the company’s market capitalization by its total sales over a specified period.
As a concern with per-share, this ratio is obtained by dividing the stock price by sales per share.
The P/S ratio is also popularly called as a “sales multiple” or “revenue multiple.”
The Price to Sales ratio is particularly helpful for valuing new start-ups companies that have high growth potential. Due to the newly formed company is not able to generate noteworthy profits until now.
PSR is also a valuable tool to measures the companies in cyclical industries or temporary negative income, but viewing signals of revival.
Price to sales is a very basic and easy ratio to understand valuation for the investors. This ratio simply put in front of investors to understand how much they are ready to pay for a company in its most basic form.
Generating revenue by selling goods or services is the most basic operation of a company. On the other hand, this is a market perceives to be the per dollar value of a company’s revenue.
Generally speaking, all things considered equal, a lower value of price to sales ratio is measured constructive as it represents undervaluation.
When the value of the PSR ratio is less than 1 then its good sign for the investors that the company is undervalued.
When the value is above 4 is a caution sign that the company is overvalued.
Advantage of Price to Sales Ratio
- It is an analysis and valuation instrument that gives information on how much investors are eager to pay per dollar of sales for that specific stock.
- Sales manipulation is more important for management to earn more profit or book value.
- In the case of new startups earnings may be negative although sales are never negative.
- Sales can be more consistent than earnings.
- P/S can be useful for analyzing companies with no earnings, are cyclical, or have reached maturity.
- Stock return trends can be analyzed within the context of differences in P/S values.
- A low value of this ratio implies that the stock is undervalued so good sign of investment.
- While the ratio with a higher value than the average price indicates that the stock is overvalued.
Disadvantage of P/S Ratio
- P/S ratio is not able to care whether the company makes any earnings or whether it will ever make earnings.
- While comparing with heterogeneous companies, this ratio cannot able to prove as well.
- Unprofitable companies can also show sales growth.
- PSR is not able to reflect the cost structure of a company.
- Different companies can have different revenue generation and recognition policies.
- P/S ratio does not account for debt loads or the status of a company’s balance sheet.
The most way for calculating the price to sales ratio is by dividing the market capitalization and sales into a per-share basis.
You can arrive at sales per share by dividing the company’s total sales over an assigned period of time by the average number of outstanding shares of the company.
The average number of outstanding shares represents the average of the opening and closing number of outstanding shares of a company over the assigned time frame.
Market Capitalization determines the total market dollar value of all the outstanding shares of the company.
We reach the point by multiplying the current market price of the firm’s share with the total number of outstanding shares of the company as on that date.
Total Sales in the above formula refers to the total sales of the company over a period of a given time frame.
This period can be either the previous financial year or a present year or sometimes even the forecasted sales for the next financial year that are called:
- Last twelve months
- Next twelve months
- Trailing twelve months(TTM)
But the often-used signal is total sales over the past 12 months, commonly referred to as Trailing Twelve Months (TTM), and can be found in the income statement of the company.
Example of P/S Ratio
Company X has reported its quarterly sales result for the Financial Year 2019 as follows:
Its quarterly forecasted sales for the financial year 2020 as below:
The firm X has 100 million shares outstanding as on Dec 31, 2019. The firm’s shares are presently trading at $5 per share.
What will be the P/S ratio for the years 2019 and 2020?
Before calculating the P/S ratio, we will have to calculate the following values like:
- Calculate the total sales separately for each year
- Calculate the sales per share separately for each year
First calculate the total sales for each year.
The total sales for the year 2019 will be:
FY 2019 = 100+110+115+125 = 450
The total sales for the year 2019 will be:
FY 2019 = 125+140+155+165 = 585
Now we can calculate the sales per share for each of the years:
|Total Sales/ Number of shares outstanding||450/100||585/100|
|Sales Per Share||4.5||5.85|
Now putting Price to sales formula to calculate the ratio:
As you can see from the above example, the PSR of firm X is forecasted to improve significantly from 1.11 to 0.855. The reason behind this growth is projected sales growth of 30% in the year 2020.
To analyze the firm X’s stock is overvalued or undervalued, you require to compare it with the industry’s P/S ratio.
Simply say, the industry’s P/S ratio is 1, then it can be concluded that firm X’s stock is trading at a premium valuation in 2019 but is expected to observe a fall in valuation in the year 2020.
Interpretation and Analysis of Price to Sales Ratio
The Price to Sales Ratio works by measuring the company’s fairly estimated worth against its revenues.
For instance, if an investor wants to settle on whether to purchase shares in a start-up that is yet to turn profitable, he can take a gander at the P/S ratio to choose whether the company’s stock is exaggerated or underestimated.
He can do this by comparing the P/S ratio of the company with that of companies in the same industry. On the off chance that the industry’s P/S ratio is higher than that of the start-up, at that point it may merit investing in the share.
P/S ratio is also a significantly important tool in situations where the use of the Price Earnings ratio (P/E ratio) probably won’t be very advantageous.
For instance, in an industry like FMCG (Fast Moving Consumer Goods), the P/E ratio of most companies is very high.
In such cases, if investors take a gander at the P/E ratio as an indicator of valuation that would not provide the genuine picture.
In such cases, PSR could be a decent measure to see whether a particular FMCG stock is exaggerated or underestimated based on its revenues.
PSR can also be useful in distinguishing turnaround situations. Say, a company has suffered a temporary setback and has not produced profits because of which share prices are at an unequaled low, a shrewd investor can use the company’s income as an indicator to measure its development, instead of its earnings.
Albeit very instinctive, PSR comes with its own set of limitations.
PSR is not useful to compare companies across industries. Sales turnover probably won’t be a reasonable indicator for companies in specific sectors such as innovation and service where the per dollar income is a lot higher than what you may see in say, FMCG or construction companies.
The other increasingly important issue is with the P/S ratio itself. The ratio ignores two important money related wellbeing indicators – obligation and profitability.
As much as turnover is an important money related wellbeing indicator, a company’s definitive objective is to create profits.
On the off chance that a company keeps developing aggressively without creating profits over a sustained period, at that point it is essentially destroying investor riches. PSR completely ignores this factor.
A company’s obligation is an important factor that needs to be considered while esteeming a stock.
For instance, on the off chance that you are comparing two companies (one utilized and the other unleveraged) with the same P/S ratio, at that point the unleveraged one is the more appealing option.
This is so because a utilized company may need to create higher sales than an unleveraged company to service its obligation.
Because of its limitations, one can presume that the investment decision should not be based on just this one measurement.
A savvy investor should always use a wide scope of pertinent budgetary and valuation ratios and metrics to esteem a company’s stock price.