What Is a Good Price-to-Sales (P/S) Ratio?
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The price-to-sales (P/S) ratio is a profitability analysis tool used to compare companies and discover undervalued securities. P/S ratios can vary significantly between industries and companies so it’s important to view a company’s P/S ratio in comparison to similar companies within the same industry.
An investment is generally more attractive when it has a lower P/S ratio calculation.
Key Takeaways
- The P/S ratio measures how much equity received from investors is necessary to deliver $1 of revenue.
- The P/S compares the company’s market capitalization to its revenue from the last 12 months.
- The ratio is most useful when comparing similar companies in similar industries.
- You can calculate the ratio on a per-share basis or a company-wide basis.
- A company with a lower P/S ratio will typically be a more favorable investment when comparing similar companies.
Understanding the Price-to-Sales Ratio
The P/S ratio is an investment valuation ratio that shows a company’s market capitalization divided by its sales for the previous 12 months. It’s a measure of the value investors are receiving from a company’s stock by indicating how much equity is required to deliver $1 of revenue.
The metric is also referred to as the revenue multiples or sales multiples.
Analysts prefer to see a lower number. A ratio of less than 1 indicates that investors are investing less than $1 for every $1 the company earns in revenue.
When to Use the Price-to-Sales Ratio
The ratio should only be used when comparing similar companies within similar industries against each other. The P/S ratio of one industry may vary greatly from the ratio of another because different entities and different sectors have varying capital requirements.
The P/S ratio is also useful when analyzing companies with similar financing structures, especially considering companies that don’t carry debt. Two companies earning the same total revenue can have different P/S ratios if one is highly leveraged while the other relies heavier on share offerings because the P/S ratio doesn’t consider debt financing.
Important
The metric can be calculated based on aggregate totals or a per-share basis:
- Price-to-Sales Ratio = Total Company Market Capitalization / Total Company Sales
- Price-to-Sales Ratio = Market Value per Share / Sales per Share
The P/S ratio can be a particularly good metric for evaluating companies in cyclical industries that may not show an actual net profit every year. The P/S ratio considers a company’s past 12 months of revenue so it absolves any cyclicality or seasonality. It’s not as useful when analyzing young emerging companies, however, because the metric doesn’t consider future growth potential.
The P/S ratio is also useful when analyzing companies with negative earnings or negative cash flow. It only looks at a company’s revenue and not its operating expenses or profit margin. Companies may not be profitable but the P/S ratio analyzed over time can detect revenue growth and emerging efficiencies in operations before the company ends up turning a profit.
What Does a High Price-to-Sales Ratio Indicate?
Higher P/S ratios may indicate that a company isn’t efficiently using investor funds to drive revenue. Lower P/S ratios are more favorable when comparing similar companies across similar industries.
What’s the Average Price-to-Sales Ratio?
Each industry has its own average P/S ratio. What might be an average P/S for one sector may be considered a very high or very low ratio for another.
How Do You Analyze a Price-to-Sales Ratio?
A P/S is analyzed by comparing it against similar companies or industries. Investments with lower P/S ratios are generally more attractive as this indicates the company is generating more revenue for every dollar investors have put into the company.
The Bottom Line
Less usually means more with P/S ratios. A lower ratio is often a sign of a good investment but all metrics come with caveats and cautions. The P/S ratio is most reliable when it compares similar companies in the same industry because they typically have similar capital requirements and face the same sorts of challenges. Be sure you have a handle on all its implications before you rely on it for your investment decisions.
The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimer for more info.
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