The Price to Sales ratio, also known as the P/S, is a valuation metric employed to determine how much investors are willing to pay for each $ of sales. Even though sales along don’t necessarily indicate profitability, a company that can produce steady sales throughout time will often be granted with a higher P/S than companies with a high volatility in its revenues.
What is the Price to Sales Ratio?
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The P/S metric is employed by investors and analysts to determine how valuable sales are for the market. Mature companies with a solid past record of sales are often the most favored by this metric, as analyst can depend on the steadiness of this track record to predict the price of the stock in the future.
On the other hand, profitable companies tend to be favored with a higher P/S also, as investors understand that each dollar in sales produces a profit down the line. Nevertheless, the P/S ratio doesn’t take into account the actual riskiness of the company’s financial structure, as the price of a stock reflects the value of its equity and not the entire value of the enterprise. For this reason, the P/S metric is often calculated along with the EV/S indicator, which stands for Enterprise Value to Sales.
Price to Sales Ratio Formula
The formula to calculate the Price to Sales ratio is the following:
P/S = Price per Share / Sales per Share
Price Sales Ratio Equation Components
Price per Share: The current market value of each of the company’s outstanding share.
Sales per Share: Net sales divided by the number of outstanding shares.
This formula can be calculated at any given point in time for a company, yet, the sales figure employed for the Sales per Share calculation should be carefully estimated.
For example, if the analyst wants to compare the P/S evolution on quarterly sales he should calculate the P/S for quarterly sales figures for perhaps the last 12 quarters. If the analyst will compare this metric with those of similar companies, the calculation should also be done on a quarter-per-quarter basis for those companies.
As a result, the P/S calculated for annual sales will always be lower than the P/S calculated for quarterly sales. Yet, comparatively, both are valuable indicators as long as they are compared with other P/S metrics estimated on the same time frames.
Price/Sales Ratio Example
Femme Products is a company that produces skin care cream, sun block cream, body washes, shampoo and many other beauty care and personal care products specifically for women. The company is publicly traded and an analyst from Guardian Financials has been looking into its valuation metrics recently to determine if the company is an attractive investment opportunity or not.
Femme Products financial information indicate that they currently have 12,390,000 shares outstanding and their sales for the last 5 years are the following:
- 2014: $145,000,000
- 2015: $139,000,000
- 2016: $167,000,000
- 2017: $175,000,000
- 2018: $172,000,000
Additionally, the price of the shares has closed each of these years as follows:
- 2014: $39
- 2015: $35
- 2016: $41
- 2017: $45
- 2018: $45
For each year the price of the P/S metric will be calculated as stated in the formula above.
P/S2014: $39 / $11.70 = 3.33
P/S2015: $35 / $11.21 = 3.12
P/S2016: $41 / $13.48 = 3.04
P/S2017: $45 / $14.12 = 3.19
P/S2018: $45 / $13.88 = 3.24
The average P/S of Femme Products’ industry is 2.5. This means that the market values Femme Products at a higher multiple of sales than its peers.
Price to Sales Ratio Analysis
One of the ways the Price to Sales ratio can be employed for valuation purposes involves forecasting the business’ sales for the next 5 years to estimate the value of the entire company, if the P/S is consistently the same as it was in the example above.
Let’s say that Femme Products forecasted sales for 2019 are $186,000,000. Considering that the P/S ratio has fluctuated between 3.00 and 3.30 in the last 5 years, an analyst can safely assume that the company’s price per share by then would be 3 times the sales per share.
According to this analysis, the price per share by 2019 will be between $45 and $49. This shows that this metric can be employed to quickly estimate the future value of a business by analyzing its past record. If a pattern can be identified on the Price to Sales indicator that would be a valuable insight, as it will allow the analyst to make sound assumptions on the future behavior of share prices. On the other hand, if a pattern cannot be identified, the metric becomes useless for the purpose of analyzing or valuing the business.
In any case, a high Price to Sales metric doesn’t really indicate something by itself. It must be compared to the P/S of peer companies or even the industry average to draft a conclusion on it. Also, it should be accompanied by a Price to Book and a Price to Earnings analysis, which can also be compared to other firms, to make sure there is enough information to make an informed decision on whether the shares are fairly priced.
Price/Sales Ratio Uses, Cautions, Pitfalls
It is important to estimate the time series of the P/S ratio for the company for past years to understand the behavior of this metric at other moments in time. The importance of doing this relies on the fact that a company with a volatile P/S indicates that other elements besides sales are affecting its valuation.
On the other hand, a company with a consistent P/S metric indicates that the market relies heavily on sales as one of the main drivers for profitability. Therefore, as sales grow, the value of the firm will also experience an increase.
Additionally, it is important to analyze the volatility in price before the formula is calculated. Knowing which price is the right one for the calculation, if the price has been volatile lately, can lead to misleading or distorted results based on short-term fluctuations. For this reason, the analyst should make sure the price he uses for the calculation accurately reflects the financial picture of the underlying business.