Price to Sales Ratio
This is a detailed guide on how to calculate Price to Sales Ratio (P/S or PSR) with thorough interpretation, analysis, and example. You will learn how to use its formula to perform a company’s stock valuation.
Definition - What is Price to Sales Ratio?
When comparing companies in similar industries, the price to sales ratio (P/S or PSR) is an important metric used to calculate a relative value.
The P/S ratio is used to evaluate a company's worth with respect to its trailing twelve-month (TTM) sales.
Taken alone, the ratio does not provide meaningful data, but, as with most ratios, taking the PSR of several comparable companies can highlight the potentially undervalued ones.
You can easily calculate the price to sales ratio by using the following formula:
Price to Sales Ratio = Market Capitalization / TTM Sales Revenue
As you can see, to calculate the price to sales revenue ratio, you merely take the market capitalization of the stock and divide it by the TTM Sales.
The number you receive when using this formula is called a sales multiple (or revenue multiple).
A sales multiple of 3 means that the company is worth 3x its sales. In other words, for every $3 of sales, the company is worth $1.
Okay now let’s consider a quick example so you can understand clearly how to calculate the P/S ratio.
Suppose a company has a share price of $10 with 10 million shares outstanding.
Additionally, in the last twelve months, the company has produced $25 million in sales.
To calculate the P/S ratio, the two components of the equation, namely market capitalization and TTM Sales, must be found.
The latter was given, and the former can be computed to be $100 million ($10 per share x 10 million shares outstanding).
Then, plugging in market capitalization and TTM Sales into our equation, we obtain a P/S ratio of 4.
So in this example, the company in question has a price-to-sales ratio of 4.0.
Interpretation & Analysis
What exactly does a price to sales ratio show? Taking the P/S ratio of one company does not show any valuable data.
But if the price-to-sales ratios of many companies in the same industry are taken, the company whose revenue is undervalued could potentially be spotted.
For example, if you are calculating the PSR of fifteen industrial companies, and the PSRs of fourteen of them are above 10, and the PSR of one of them is 5, the company with the low PSR could very possibly be undervalued.
Meaning, that the market is valuing each dollar of sales at $5 for one company, and at over $10 for the other fourteen companies.
Would you rather pay $5 for $1 in sales, or $10 or more for it? Obviously, the former.
Cautions & Further Explanation
As with any ratio, you must be hesitant to make an investment decision strictly on the results of the price to sales ratio.
While it is possible that a low P/S ratio could be an indicator of an undervalued asset, there exist multiple explanations as to why the P/S ratio would be so low.
For example, a company expecting to generate considerably less revenue in the upcoming year than it did in the previous year, or a company with significantly larger expenses than its peers, would be valued at a lower price than its competitors, thereby yielding a lower sales multiple.
So, a company with a low price-to-sales ratio is not always undervalued.
Therefore, you must always utilize various financial metrics and ratios to ascertain a company’s financial health.