The price-sales ratio is one of many tools to help you with investing
Successful investing is, among other things, a numbers game. Not just any numbers game, though. Numbers only paint part of the picture. Before you invest in a company, you need to know its financial history, how they allocate funds, and you want to have some idea of what kind of return you can expect for your investment.
One way to do this is by looking at the price-sales ratio. The price-sales ratio is one measure used to determine the value of a company’s stock. One way to use this ratio is as a comparison against other, similar companies, to estimate how well a company is performing.
The price-sales ratio (also called PSR or P/S ratio) uses the price of a company’s stock and the total of a company’s sales to indicate the value of that company’s stock. The aim is to determine if the stock is valued correctly.
Like most of these measures, the price-sales ratio should not be used exclusively to determine the value of a stock. Smart investors will use the price-sales ratio as one of many tools to evaluate a potential investment.
It will give you an idea of how healthy a company is. Likewise, the price-sales ratio can also give you some insight into how you may be able to benefit from a particular stock.
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How price-sales ratios can signal future gains
Sales are the raw material of earnings; that is, sales minus expenses equals earnings, so earnings are always less than sales.
If a stock has a very high price-sales ratio — 20, say — its rate of sales growth will have to be very high if it is ever to earn enough profit to justify its current stock price, let alone a higher price.
How to use the price-sales ratio to your best advantage
We include a price-sales or p/s ratio with the stocks we cover in most of our investment newsletters. It lets investors see how the stock is doing relative to the company’s sales.
As mentioned, you get the price-sales ratio when you divide a stock’s price by its sales per share (you calculate a stock’s sales per share by dividing its total annual sales by the number of shares it has outstanding).
The basic rule is that a lower price-to-sales ratio means that a stock is cheap. A higher price-to-sales ratio tends to indicate that a stock is expensive. Still, many individual stocks seem to run counter to this rule. Stocks with deservedly high price-sales ratios can rise for lengthy periods, and stocks with deservedly low price-sales ratios can fall.
That’s why it’s important to keep price-to-sales ratios in perspective. They tend to provide hints rather than clear answers. They are only one among many tools in your stock research.
On the other hand, you might uncover a company with an extraordinarily low price-to-sales ratio, such as .01 (for example, a $1 stock with $100 a share in sales). That can indicate a lot of capital-gains potential, if the company can improve its profit margin.
However, a low price-sales ratio is only an advantage if a company can make money on its sales. If the company can’t make a profit, its low price-sales ratio may signal danger, rather than a bargain. The low p/s may reflect the fact that well-informed investors are selling the stock (and driving down the price). Money-losing companies eventually go out of business, and that is not where you want to invest your money.
Using financial ratios to help you invest wisely
Use more than just one financial ratio when you research a stock, so that you see more than one aspect of the story. No matter how many financial ratios you consult, remember they only give you a partial view of the company’s strengths and weaknesses.
You will still need to investigate a company thoroughly to help you decide if you want to invest. Make sure you get a complete picture before you make a financial commitment to a stock.
What is your experience with using the price-sales ratio? If you’ve used it, did you find it helpful? Why or why not? Let us know in the comments.