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

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.

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 twelve months, a low price-to-sales ratio is one of the most potent combinations of investment criteria. A low price-to-sales ratio can also be effective in valuing growth stocks that have suffered a temporary setback.

In a highly cyclical industry such as semiconductors, there are years when only 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. Price-to-sales 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 price-to-sales ratio will show whether the firm's shares are valued at a discount against others in its sector. Say the company has a price-to-sales ratio 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 price-to-sales ratio 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, price-to-sales represents one of the last remaining measures for valuing the business. All things being equal, a low price-to-sales ratio is good news for investors, while a very high price-to-sales ratio can be a warning sign.

Where P/S Fall ShortThat being said, turnover is 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, earnings are a complicated bottom-line number, 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 margins and their trends, as well as with sector-specific margin idiosyncrasies.

Debt Is a Critical Factor

A firm with no debt and a low price-to-sales metric is a more attractive investment than a firm with high debt and the same price-to-sales ratio. 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 price-to-sales ratio.

Debt-laden companies on the verge of bankruptcy, however, can emerge with low price-to-sales ratios. 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 market capitalization/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.
by Ben McClure