How to Use Price-to-Sales (P/S) Ratios to Value Stocks

Fact checked by Jared EckerReviewed by Somer AndersonFact checked by Jared EckerReviewed by Somer Anderson

How the Price-to-Sales (P/S) Ratio Works

The price-to-sales (P/S) ratio expresses how much it costs to purchase one share of a corporation, in relation to how much revenue it creates for the company. By analyzing a company’s market capitalization and revenue, this metric helps determine whether the stock is valued properly. It is calculated by taking a company’s market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company’s total sales—or revenue—over the past 12 months.

The P/S ratio provides a useful measure for comparing stocks. For most investors, the lower the P/S ratio, the more attractive the investment is.

What You Need to Know

• The price-to-sales (P/S) ratio utilizes a company’s market capitalization and revenue to determine whether the stock is valued properly.
• P/S ratio is calculated by taking a company’s market capitalization and dividing it by the company’s total sales—or revenue—over the past 12 months.
• Companies with a lower P/S ratio are generally more attractive to investors.

Understanding the Price-to-Sales (P/S) Ratio

The price-to-sales ratio reveals how much the market values every dollar of a company’s sales. This ratio can be effective in valuing growth stocks that have yet to turn a profit (or have suffered a temporary setback).

For example, if a company isn’t making earnings yet, investors can only use the P/S ratio to determine whether the stock is undervalued or overvalued. If the P/S ratio is lower than comparable companies in the same industry, investors might consider buying the stock because it’s undervalued. There might be an opportunity to make higher returns when this stock is correctly valued by the market in the future.

Of course, the P/S ratio needs to be used with other financial ratios and metrics when determining whether a stock is valued properly. In a highly cyclical industry, such as semiconductors, for example, there are years when only a few companies produce any earnings. This does not mean semiconductor stocks are worthless.

Using the Price-to-Sales (P/S) Ratio to Evaluate Negative Earnings

If a company’s earnings are negative, the price-earnings (P/E) ratio is not an optimal metric because it will not be able to value the stock. After all, the denominator is less than zero. Investors can use the price-to-sales (P/S) ratio—instead of the P/E ratio—to determine how much they are paying for a dollar of the company’s sales (rather than a dollar of its earnings).

The price-to-sales (P/S) ratio can be 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 with which investors can assess the shares.

Let’s consider how to evaluate a firm that has not made any money in the past year. Unless the firm is going out of business, the P/S ratio will show whether the firm’s shares are valued at a discount against others in its sector.

Suppose the company has a P/S ratio of 0.7—while its peers have an average P/S ratio of 2.0. If the company turns things around, its shares will enjoy substantial upside, as the P/S ratio 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.

Note

All things being equal, a low P/S is good news for investors, while a very high P/S can be a warning sign.

Disadvantages of Price-to-Sales (P/S) Ratio

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.

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.

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 those findings with those of other companies in the same industry.

Considering Debt in Relation to Price-to-Sales (P/S) Ratio

The price-to-sales (P/S) ratio does not account for the debt on a company’s balance sheet. A firm with no debt and a low P/S metric is a more attractive investment than a firm with high debt and an equivalent P/S metric. At some point, the debt will need to be paid off, and the debt has an interest expense associated with it. As a valuation method, the P/S ratio doesn’t consider that companies with high debt levels will ultimately need higher sales to service the debt.

Companies heavy with corporate debt and on the verge of bankruptcy, however, can emerge with a low P/S ratio. This is because their sales have not suffered a drop, while their share price and capitalization collapses.

However, 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. Enterprise value incorporates a company’s long-term debt into the process of valuing the stock. 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). (Consider the EV as the total cost of buying the company, including its debt and leftover cash.)

What Is a Good Price-to-Sales (P/S) Ratio?

Generally, a smaller price-to-sales (P/S) ratio (i.e. less than 1.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales do not reveal the whole picture, as the company may be unprofitable and have a low P/S ratio.

What Is a Good Price-to-Sales Ratio for a Growth Company?

Companies with a P/S ratio of 0.75 to 1.5 are regarded as strong buys. Those having a PSR greater than three are deemed high-risk. However, a low P/S ratio is not the only metric to consider. While a lower one is usually a good sign, companies that are growing fast usually have higher P/S ratios because people expect them to make more money in the future. 

What Is the Difference Between the Price-to-Sales (P/S) Ratio and the Price-to-Earnings (P/E) Ratio?

The price-to-sales (P/S) ratio compares a company’s stock price to its annual revenue (sales). The price-to-earnings (P/E) ratio compares a company’s stock price to its annual earnings (profit),

The Bottom Line

As with all valuation techniques, sales-based metrics are only part of the picture. Investors should consider multiple metrics to value a company. A low P/S ratio 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 ratio can be a false indicator of value.

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