Price to sales ratio
A company's market cap divided by the company's annual sales (or revenue) gives us the price/sales ratio.
The price/sales (p/s) ratio is a method for valuing a company, similar to other metrics such as the price/earnings (p/e) ratio and the price/book (p/b) ratio. A firm’s p/s ratio is usually calculated by dividing its market capitalisation by its revenues. So a company with a market cap of £25bn and sales of £10bn has a p/s ratio of 2.5.
You’d get exactly the same result if you divided the share price by revenues per share. But unlike earnings or book value, revenues aren’t usually reported on a per share basis, so using total sales means one less step in the calculation.
Just like a p/e ratio, a low p/s ratio may imply a cheap stock. However, sales aren’t the same as profits, so the p/s ratio requires even more care when deciding if a stock is cheap.
Different sectors have very different profit margins, so the p/s ratio is most useful when comparing companies within the same sector. It can be especially helpful when looking at firms whose earnings are temporarily depressed as a result of one-off factors, but which should later return to a more normal level. This is often the case in cyclical industries.
The p/s ratio can also be useful when comparing early-stage growth stocks against their peers. These firms may be growing rapidly, but not yet making a profit, rendering the p/e ratio useless. The p/s ratio tells you how much the market is paying for each pound of sales. Of course, the value of this depends on whether your assumptions about a firm’s future profitability are realistic: a business with little prospect of making a profit will be a bad investment even if the p/s ratio is low.
The p/s ratio does not take debt into account. This means that when one firm has more debt than an otherwise identical rival, it will look cheaper (but may well be riskier). To get a picture that includes debt, use enterprise value (equity market capitalisation plus the value of outstanding debt) divided by sales instead.
Watch Tim Bennett's video tutorial: What is the price-to-sales ratio?