Value-oriented traders seek to buy stocks when they are “cheap.” While that is a relative term, the goal of fundamental analysis is to make an objective assessment of the value the market is placing on a given stock relative to the value of the underlying company. One simple but especially useful tool in this process is the price to sales ratio (P/S).
Components of P/S ratio
The price-to-sales ratio is an indicator that compares a company’s stock price to its revenues and measures the value placed on each dollar of a company’s sales or revenues. The P/S is typically calculated by dividing the current price of the stock by sales per share over the previous 12-months. So if a company had $100 million of sales in the past 12 months and there are 10 million shares of stock outstanding, then the company sales per share is $10 ($100 million / 10 million shares). If the stock is trading at $20 a share then the P/S would be 2.0 ($20 / $10). However, if the stock is trading at $10 a share then the P/S would be 1.0. So the lower the P/S the more undervalued a stock is considered to be, and the higher the P/S the more overvalued a stock is considered to be.
What traders look for
As with most value ratios, a low P/S may indicate possible undervaluation, while a ratio that is significantly above average may suggest overvaluation. The P/S is most relevant when compared to the company’s own P/S historical range, and when compared to other companies in the same industry.
One benefit of analyzing price-to-sales figures is that it can be more stable than price-to-earnings figures. Even when a company reports a loss for a quarter or a year, they still are making sales.
While a company’s earnings may change dramatically from quarter-to-quarter and/or year-to-year based on a variety of business factors, sales data is typically much less volatile in terms of year-to-year changes.
P/S can be a useful analysis tool when identifying potentially undervalued stock candidates. According to some studies, stocks with a P/S of less than 1.0 have shown a tendency to outperform stocks with a P/S greater than 1.0. However, it should be noted that these tests are based on looking at hundreds of stocks and there is no guarantee that any individual stock will perform well simply because its P/S is presently below 1.0.
What traders look out for
Stock prices tend to move to extremes. As a result, it is possible for a stock to appear undervalued based on a low P/S, only to then decline even more before bottoming at an extremely low P/S. In other words, P/S below 1.0 should be viewed as a potential “alert” signal and not necessarily as a “buy” signal.
On the other end of the spectrum, if the P/S for a given stock reaches historically high levels based on its own history, and/or if its P/S is well above the average stock in its industry group, value oriented traders may view this as an “alert” signal that the stock’s current price may prove unsustainable in the long run.
Because sales data is typically less volatile than earnings data, the historical range for P/S data for a given stock is typically well-defined. As a result, a relatively low P/S for a given stock can be an extremely useful tool for identifying undervalued opportunities.