Definition
Price to Sales Ratio is basically how much the market is willing to pay for every $1 of revenue earned in a year. It is calculated by dividing the current share price to revenue per share.
P/S ratio is dependent on stock price and revenue of a company. Since the stock price always go up and down, the exact ratio also changes every time. It is also called sales multiple.
This ratio is one of the basic metrics used to determine a company’s value. The advantage of this ratio compared to P/E ratio is that this can value companies that loses money.
Note :
Revenue is the total money generated by a business from selling products or services before paying expenses associated from generating that revenue. Revenue is also called Sales.
Formula
P/S Ratio = Market Cap (Share Price) / Net Sales (Revenue per share)
Sales multiple of 2.5 means a stock is currently valued at $2.50 per $1 of revenue in a year.
In Simpler Terms …
Sales multiple is directly related to revenue and the current price of a stock. The more expensive the stock, the higher the ratio, while the cheaper the stock, the lower the ratio.
On the other hand, higher revenue makes the ratio lower, and lower revenue will result to higher ratio.
That’s why most investors prefer lower P/S ratio.
Example – P/S of Apple stock
On December 9, 2019, Apple stock closed the day trading at $266.92 per share. During its last quarterly report, Apple reported roughly $260 billion in revenue which translates to $55.96 revenue per share.
Price to Sales Ratio = Share Price / Revenue per Share
= $266.92 / $55.96 = 4.77
This means that Apple stock was trading at P/S ratio of 4.77 on December 9. It means that investors are willing to pay $4.77 per $1 of sales earned.
Why is P/S Multiple Important?
Many stocks today, especially new companies, is losing money and has negative earnings. If a company is losing money, it has no Price to Earnings ratio, which means that Sales Multiple can give an investor an idea about the value of a business.
Sales multiple is useful to companies that are losing money as they do not have P/E ratio.
Generally, a lower Sales multiple is considered safer and better by most investors; and a high ratio usually means more riskier, but could deliver more returns if selected the right stock.
On the other hand, P/S is only one indicator to value a stock correctly. If Company A and Company B has the same projected growth, same balance sheet, and the only different is the P/S multiple, that’s when you’re sure that a stock is better valued.
Average P/S ratio of S&P 500
The average P/S ratio of S&P 500, the most common stock market benchmark, is around 2.2. During the last 5 years, the average multiple of S&P 500 has always been between 1.7 and 2.3. It is the average sales multiple of the 500 biggest companies in the US stock market.
P/S ratio depends on every industry. Retail and commodities stocks like Walmart and Coca-cola tend to have a lower ratio.
On the other hand, technology stocks like Amazon tends to have a higher multiple.
A ratio of 5 may be too low for a technology stock, while a ratio of 2 may be too high for a retail business. Every industry has different ratios.
When does a stock trades at a High Sales Multiple?
Stocks that trade at a high multiple usually has a lot of growth projected in the future.
Some stocks have revenue growth of 50-80% per year and projects consistent monster growth. Thus, investors are willing to pay higher multiple on these kind of stocks.
These are what they call Growth Stocks. Examples include SHOP, PAYC ,TTD ,UBER, and LYFT.
Stocks that trade at a high multiple tends to have a higher volatility and can normally go up or down as high as 5% in any given day without any relevant news that could change a company.
Also, be always cautious when buying stocks with a high sales multiple as most of the time they are way overpriced.
Active traders usually put money in volatile stocks with high multiple, and that makes a stock go up a lot in the short term as it is artificially inflated by active money.
When most of active traders decide that a stock is overvalued, most of them will sell and more active traders tends to sell more to avoid losing more money. Thus, it can make a stock go up or down a lot in a short period of time because of active money.
Why does a stock trades at Low Sales Multiple?
Stocks that trade at a lower multiple tends to have no growth in revenue or even shrinking revenue.
When a company is projected to have 1-2% in sales growth or in some cases decreasing revenue, investors tend to discount the stock and thus makes the multiple lower.
The perfect example of this is Coca-cola. Since almost every person in the world already knows and recognize the brand, future growth is limited as there is almost no more opportunities to expand the business.
Limitations of P/S Ratio
While this ratio can be useful if used right, is has some limitations. First, no single number can determine whether a stock is undervalued or overvalued. Also, P/S ratio does not into account earnings of a company. If a business is losing more than it earns, this ratio will not tell you that.
Moreover, it does not take into account the condition of the balance sheet of a company. A company may have a lot of debt, but this ratio does not take into account those debt. It only considers the current price and the revenue it earned.
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