The price-to-sales ratio (PSR) compares a company’s market capitalization to its revenue for the past 12 months, providing an indicator of whether a stock is overvalued or undervalued. It can be useful for new companies or those with cyclical fluctuations or unusual expenses. Comparing PSRs between companies in the same industry is important, and other financial data should also be considered before making investment decisions.
A price-to-sales ratio (PSR) compares the total value of a company’s outstanding shares to total revenue for the past 12 months. The lower the price/sales ratio, the higher the value of each share compared to each dollar in sales. The PSR is a quick comparison that gives potential investors an idea of whether a company’s stock is overvalued or undervalued.
The total value of shares outstanding is calculated by multiplying the number of shares outstanding by the current market price of the shares. The resulting value is called the market capitalization. The revenue figure used in the calculation is revenue for the prior 12 months, or the prior four quarters, as published by the company in its financial statement or quarterly reports. This period of time is also called the last 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 track record of sales, this ratio can provide an indicator of value. If a company has lost money in the last 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 modify 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 company value. This increased number causes the ratio to increase. This modified relationship allows the evaluator to compare two companies where one has substantial debt and the other does not. A company with high sales performance backed by high levels of debt may or may not be as much of a bargain as a company with modest sales but little debt.
To use the price/sales ratio effectively, you need to compare companies within the same industry or understand the differences. The difference in the typical PSR between two industries can vary substantially. The seemingly low ratio for a software company might not be as good as the higher ratio for a manufacturer that is actually lower compared to its competitors.
There are many other pieces of 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 reviewed alongside other financial data. Making an investment decision solely on the basis of a relationship could completely overlook other issues facing the company in question.
Smart Asset.
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