Price to Sales Ratio

Price to sales ratio (P/S ratio) is the ratio of a company’s current stock price to its net sales revenue per share. Price to sales ratio is a relative-valuation measure which values a company with reference to the sales revenue it generates. There are situations in which P/S ratio is more meaningful than the more popular ratios such as the price to earnings (P/E) ratio, etc., for example when there is net loss or where the net income is manipulated through creative accounting.

Revenue is the most top-level parameter of a company’s financial performance. It is less prone to accounting manipulations as compared to net income even though complete understanding of a company’s revenue recognition policies is needed to correctly adjust revenues earned in each period.

Formula

Price to sales ratio is calculated by dividing the current stock price by the net revenue per share. Following is the formula:

 Price to Sales (P/S) Ratio = Current Stock Price Revenue per Share

Net revenue per share is calculated by dividing the net revenue, i.e. gross revenue minus value-added tax (VAT) or any other taxes and sales returns and trade discounts, divided by weighted average number of shares of common stock during the period.

Price to earnings (P/E) ratio is the product of price to sales (P/S) ratio and net profit margin:

Price to Sales Ratio = Price to Earnings Ratio × Net Profit Margin

Strengths and Weaknesses

P/S ratio is useful because:

• It can used to value a company when the P/E ratio is meaningless i.e. when the company is incurring net loss. P/S ratio is positive even when a company has negative P/S ratio.
• Empirical evidence suggests that a company’s sales revenue is a good predictor of its stock performance.
• While the denominator in P/E ratio i.e. EPS is affected by accounting policies and estimate relevant to each revenue and expense item, P/S ratio is affected only by revenue recognition policies and estimate which makes it less prone to manipulation by management.
• Because revenue is less volatile than net income, P/S ratio is more stable than P/E ratio.

However, P/S ratio has some serious weaknesses, for example:

• Revenue per share does not tell us the whole picture because it does not capture the effect of a company’s cost structure and capital structure, i.e. just generating high revenue is not enough because investors worry about net addition to their wealth which is achieved only when the revenue translates to net income.
• The numerator in the P/S ratio i.e. the stock price is affected by capital structure, but the ratio’s denominator does not reflect the impact of financing which creates a potential disconnect between two variables.
• Even though P/S ratio is less prone to accounting manipulation, it is not immune to manipulation. The revenue recognition policies must be thoroughly studied to make sure revenue is not overstated or understated in a period.

by Obaidullah Jan, ACA, CFA and last modified on

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