When you are looking for companies to invest in, the Price-Sales ratio (P/S) is a good indicator to see the faire valuation of a company. Let’s see together how it works.
Calculation of P/S
To find the P/S value, you have to calculate the company’s market capitalization, and then divide it by the company’s total sales/revenue from the last 12 months.
A lower P/S will significate will mean a company is fairly valued.
How to use the P/S
We can use as we said earlier, if a company is fairly valued and its price is not out of boundaries.
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. Let’s say the company has a P/S of 0.7 while its peers average a 2.0 for P/S. 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 also lose 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 Falls Short
That being said, turnover is valuable only if, at some point, it can be translated into earnings. Consider construction companies, which have high sales turnover, but (with the exception of building booms) make modest profits. 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.
Some investors view sales revenue as a more reliable indicator of a company’s growth. Although earnings are not always a reliable indicator of financial health, 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 margins and then comparing the findings with other companies in the same industry.
The Bottom Line
As with all valuation techniques, sales-based metrics are only part of the solution. Investors should consider multiple metrics to value a company. Low P/S can indicate unrecognized value potential—so long as other criteria exist, like high-profit margins, low debt levels, and high growth prospects. Otherwise, the P/S can be a false indicator of value.