Understanding price to sales ratio

Hi there ,

We learned about P/E ratio in our earlier article. P/E ratio is useful for evaluating companies with adequate earnings. But in some cases, especially in the case of promising start up companies, earnings of the company may not be anything much to talk about. The reason could be high amounts spent for further expansion. In such cases, instead of P/E , P/S would be used. That is, we try to figure out what the market is willing to pay for a share of company’s sales. The higher the P/S the more the market is willing to pay for the company’s sales generated.

HOW IS IT CALCULATED?

Price to sales ratio relates market value of the company to it’s annual sales. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company.

You can also calculate the P/S by dividing the current stock price by the sales per share.

P/S = Market Cap / Revenues

P/S is an alternative method to look at companies where P/E doesn’t work. For example – Price to sales are useful to value retailing companies.

ADVANTAGES AND DISADVANTAGES

  • Earnings is basically an accountant’s estimate of the profits made by a company. earnings can differ according to the accounting method used and the assumptions that has gone into computing it. So, a shrewd accountant can very easily manipulate the earnings figure of a company to please the share holders. But, sales figures are not subject to such high manipulation.
  • The flip side is that, eventually, any company should come up with profits. A business may have higher sales but a lower profit margin than a competitor, indicating that it’s not operating efficiently. what’s the benefit if a company generates crores and crores of sales but ultimately falls short when it comes to earning  profits? Ultimately , earnings is what drives the stock price up.
  • So, P/S is a tool that should be used very carefully in certain special circumstances. For example – we need to take a decision between two similar retailing companies. Both the companies are identical in all respects- EPS, Debt (borrowings) etc. You can use P/S to evaluate which company generates more volume of sales with the borrowed money. so, if leverage ( technical jargon for borrowings) is similar across companies , P/S may become useful for the investor to make decisions.
  • P/S can also be used to spot high growth companies of tomorrow which may not be reflected with P/E analysis. Companies with high potential for growth generally have low earnings due to heavy investments made in the initial years.If you assume that the future of the company is bright, P/S may be the measure you need to confirm that.

CONTRADICTION BETWEEN P/E AND P/S

    Generally, P/E of a company and P/S move in the same direction. There could be situations where P/E of a company contradicts with the P/S ratio. For example , If a company has a low P/E but a high P/S, it can be a signal that there were some one-time gains.

    That’s about price to sales ratio ..

    bye for now !

    You may like these posts:

    1. Price to Earnings ratio or P/E ratio
    2. Understanding Earnings Per Share (or EPS)
    3. More about P/E

    1 Response to “Understanding price to sales ratio”

    kushal

    November 10, 2016 at 9:03 pm

    can you add with an example

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