The Price-to-Sales explained.

The price-to-sales ratio is a “valuation metric” used to measure the value of a company compared to its annual sales (revenue). It can be measured using market capitalisation against total revenue or on a per-share basis against sales per share. The price-to-sales ratio indicates what investors are willing to pay for every dollar of sales generated by the business.

The price-to-sales ratio is one of the simplest ways to understand the valuation of a potential investment, as it helps investors know how much they are truly paying based on revenue.

The P/S is most commonly used for companies that are yet to turn a profit or pass the break-even point. It is a ratio I use when looking at companies that are either early-stage and launching or going through hyper-growth. Sometimes there are not many ratios to use especially when there are no or limited profits to value! So, investors can use other ratios that look at different metrics to compare investment ideas.

Finding companies yet to turn a profit or perhaps in a struggling position and measuring the price-to-sales against their peers can present undervalued opportunities. Most companies will have sales and therefore it can be a reliable metric used in a lot of circumstances. Cyclical businesses and companies that have depressed earnings can also show a lower P/S which is helpful in identifying undervalued investments should those businesses turn around.

A lower price-to-sales ratio is preferred (around 1 or less) as it would mean the investor is paying less for each unit of sales. It is best used when measuring unprofitable companies in the same industry or for measuring past performance of a business to see how the multiple has changed over time.

A high price-to-sales ratio can indicate that the investors are currently willing to pay a premium for each dollar of sales. This is not necessarily bad however can contribute to over valuation or “speculation” if the business does not convert to profits.

The reason sales are used as the base for the formula is that while earnings are volatile, the sales remain stable. Early-stage companies can seem highly overvalued using other forms of valuation. The ratio provides a good valuation based on the operations of a business using a key driver, revenue, disregarding any accounting adjustments.

What is the Price-to-Sales formula?

• P/S = Market Cap ÷ Total Sales
• Market Cap = Total number of outstanding Shares X Last listed share price.
• Total Sales = Found on the Income Statement.

The formula can be used in two ways, the above method or by using the current share price and dividing that by the sales per share (Total Sales ÷ Total Shares Outstanding). With the revenue, it is the TTM (Trailing Twelve Months). As we are using past numbers the ratio is a “rear looking” one.

How to use the P/S ratio?

The first example of how we can use the price-to-sales ratio is by measuring like-for-like investment ideas against one another. Certain industries have different averages and comparing a technology business to a retailer won’t give you an accurate look at whether the company is under or overvalued.

Let’s compare three companies in the same industry and roughly the same size and determine the price-to-sales of each one.

P/S	Company A	Company B	Company C
Revenue	$28.5 million	$32.8 million	$147 million
Market Cap	$107 million	$98 million	$165 million
Price-to-sales:	3.75	2.98	1.12

In this example, we can see that Company C has a lower P/S than its competitors.

Company A $107m ÷ $28.5m = 3.75 ($3.75 per $1 of sales)

Company B $98m ÷ $32.8m = 2.98 ($2.98 per $1 of sales)

Company C $165m ÷ $147m = 1.12 ($1.12 per $1 of sales)

What this means for Company C is that investors are willing to pay $1.12 per $1 in sales. We can assume that Company C is undervalued when looking at the other two companies.

Another way to invert this idea is to ask why are investors placing a premium on Company A. Are there valid reasons to push up the price or is it hope? Various factors might explain why Company A is higher, so it’s critical to understand what makes it more desirable. If you can not find a reason, then skip it.

If it were a pure value play finding the lower P/S can uncover undervalued opportunities. However, a premium P/S can also discover hyper-growth opportunities. It is all relative to what you as the investor are trying to achieve in constructing your portfolio.

In another example let’s look at an individual company and go back over the past 3 years to look at any changes to the multiple. Let us use the formula including the share price and shares outstanding.

	2021	2022	2023
Sales	$125 million	$140 million	$147 million
Market Cap	$107 million	$152 million	$195 million
Shares Outstanding	100 million	100 million	100 million
Price Per Share	$1.07	$1.52	$1.95
Price-to-sales:	0.856	1.08	1.32

This information can be useful in looking at how the P/S multiple is changing and comparing this to the industry and other competitors. In this case, we see an evolving company, revenue rising, market cap growing, and the share price starting to follow. The rising price-to-sales can indicate a lot of factors, investor speculation, changes in the market, or a rise in market share.

You can see that the share price has grown over those three years, but the sales per share increased a little slower. By looking at the P/S ratio you can see with a slight increase, investors are now paying more per share compared to previous years.

One way to reframe it is by looking at the price-to-sales ratio and asking the question: Am I prepared to pay a higher price per dollar of sales? If so, why? Work backward from there. I invert these questions and instead of being turned away from valuations that seem high to industry standards, ask could this company command a premium based on its future. What are its growth projections?

Paying a high P/S means little if you capture the beginning of a long and sustained growth company on an upward trend. A P/S of 9 might not be bad if a company can grow its Operating Margins from 5% to 25%, while a P/S of 2 might actually be expensive if a company’s growth stagnates from there.

What are the downfalls?

Some of the key downfalls to using the price-to-sales ratio are earnings and debt. While focused on sales it does not consider profit or whether a company will ever be profitable. Therefore, while it is useful in valuing an early-stage or high-growth company it is not a preferred metric for valuing other size companies especially with earnings.

The ratio also does not consider a company loaded with debt or differentiate it from a debt-free one. This means a company can report a low P/S ratio look undervalued and still go bankrupt.

In Summary…

There is no right or wrong approach to using the price-to-sales ratio. Low ratios around 1 or less than 2 are preferred mostly by value investors. Higher ratios can be preferred by growth investors. I like to use the ratio to get a gauge of a company with no profits that is at the beginning of its growth cycle. It gives me a very clear indication of where a business is and what to compare it to.

If the ratio is way off the mark compared to other early-stage peers and I can not find a valid reason behind it, then sometimes it means it is a story stock as speculation can bid these companies with no earnings to astronomical prices.

Depending on what I am looking for, either an undervalued business where I see earnings and potential profits changing in the future or a high ratio indicating a lot of expectation for the premium. I find there is a higher level of risk chasing a higher price-to-sales ratio but there can also be some great returns backing an early-stage multibagger.

Each industry and business cycle has an average benchmark which is a helpful way when we are filtering investment ideas. A glance at a company and it’s price-to-sales can flag companies for further research if we see them doing something different from the average.