What to Do
The P/S ratio is calculated by dividing market capitalization (current stock price × shares outstanding) by annual sales:
For example, if a company has a market cap of $5 million and total sales of $7.5 million, the P/S ratio is 0.67.
P/S varies considerably according to industry. For example, retailers and distributors tend to have high sales in relation to market cap, which results in a very low P/S. Similarly, manufacturers of high-cost goods tend to have lower sales figures, so the P/S ratio goes up. Bear in mind that these are trends rather than rules—share analysis is not an exact science. However, in a list of companies ranked by P/S, retailers of fast-moving, lower-priced products (such as supermarkets) will typically have the lowest ratios.
Suppose two companies in the same sector are being compared, and one has a much higher P/S than the other. The company with the higher P/S ratio is more expensive than one with a lower ratio, because investors are prepared to pay more for its sales.
Investors may regard a low P/S as an opportunity, but they will want to examine the reasons behind the figures. For example, the company may be less profitable than its competitors. It’s important to remember that the P/S ratio only examines sales, which may be far removed from profitability, which is after all what matters most.
What You Need to Know
- P/S is useful for assessing companies making a loss, when it’s not possible to calculate P/E.
- It’s also handy for evaluating young companies that have yet to turn a profit.
- Like all valuation metrics, P/S should be used with care and not in isolation.
- With this in mind, P/S can be a useful investment tool. A recent study of the New York Stock Exchange recognized P/S as an effective gauge for identifying high-performing stocks over the long-term.
Where to Learn More
Web Site:
Motley Fool, “How to use the P/S ratio”: www.fool.com/investing/value/2005/11/15/how-to-use-the-ps-ratio.aspx
