Tuesday, November 12, 2013

Price to Sales (P/S) Ratio

The most basic ratio of all is the Price to Sales ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings. In addition sales are not as volatile as earnings –one time charges can depress earnings temporarily, and the bottom line of economically cyclical companies can vary significantly from year to year.

price to sales ratio

This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.
However the P/S ratio has one big flaw. Sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions , but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio, because we have no idea what level (if any) profits the company will generate.

Therefore, although the P/S ratio might be useful if you are looking at a firm with highly variable earnings –because you can compare today’s P/S with a historical P/S ratio – it’s not something you want to rely on very much. In particular don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.