The price-to-sales ratio (PSR) compares a company’s market capitalization to its revenue for the past 12 months. A lower ratio indicates greater value for each share. The PSR is useful for new companies or those with fluctuating earnings. Adjusting the ratio to include debt can help compare companies with different debt levels. Comparing PSRs between industries requires understanding their typical ranges. The PSR should be used in conjunction with other financial data when making investment decisions.
A price-to-sales ratio (PSR) compares the total value of a company’s outstanding shares to its total revenues for the past 12 months. The lower the price-to-sale ratio, the greater the value of each share of stock relative to each dollar of sale. The PSR is a quick comparison that gives potential investors an idea of whether a company’s stock is over or undervalued.
The total value of shares outstanding is calculated by multiplying the number of shares outstanding by the current market share price. The resulting value is called the market capitalization. The revenue figure used in the calculation is revenue for the prior 12 months, or prior four quarters, as published by the company in its financial statement or quarterly report documents. This period of time is also called the final 12 months.
Using the price/sales ratio can be beneficial in several situations. If a company is new to its industry and doesn’t have a track record of earnings, but does have a history of sales, this report can provide a valuable indicator. If a company has lost money over the past year due to cyclical fluctuations in its industry or unusual expenses, the PSR offers a look at the results regardless of expenses.
Sometimes an analyst will adjust the price/sales ratio to include the company’s debt in the ratio. The market capitalization figure is added to the total outstanding debt to produce a number known as the enterprise value. This increased number causes the ratio to increase. This modified ratio allows the valuer to compare two companies where one has substantial debt and the other does not. A company with high sales performance supported by high debt levels may or may not be as much of a deal as a company with modest sales but little debt.
To use price/sales ratio effectively, you need to compare companies in the same industry or understand the differences. The difference in typical RDP between two sectors can vary substantially. The seemingly low ratio for a software company may not be as good as the highest ratio for a manufacturer which is actually lower than the manufacturer’s competitors.
There is a lot of other information to consider when evaluating a potential investment. A low price-to-sales ratio can be a good indicator that a company’s stock is undervalued, but it should be examined in conjunction with other financial data. Making an investment decision based solely on one report could completely overlook other issues facing the company in question.
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