Is a Higher Price To Sales Ratio Better? The stock market has a lot to choose from, estimated at around 14 publicly traded companies for every million people.
Understanding what to invest in is more complicated than it seems. High-profile companies like Uber, Tesla, and Amazon often trade for multitudes more than they earn, if they generate a profit at all.
One of the measures investors use to determine a company’s value is its price-to-sales ratio (P/S). At its base, it determines the company’s true market value based on its sales.
So, is higher price to sale ratio better?
We’ll explain how the number is calculated, what it should be compared to, and how it helps investors understand a stock’s value.
Understand this is just one of many ways to calculate value, and you’ll inevitably need to do as many as possible during your due diligence to ensure you’re not buying overvalued stocks and losing money.
Let’s get started by defining P/S.
What Is Price to Sales Ratio (PSR)?
Different industries have different profit expectations, just like startup companies often have to spend more to expand. Meanwhile, large enterprises and multi-national conglomerates often have to spend hundreds of millions, even billions in operating expenses.
However, sales is the lifeblood of any company, and the ability to generate sales is a strong indicator of what a company is really worth. This is why P/S is used, which divides a company’s market capitalization by the total sales over the trailing 12-month period.
A price-to-sales ratio of 1 means that investors pay $1 for every $1 of revenues the company generates. Lower price-to-sales ratios mean you’re spending less than $1 to earn $1, while higher ratios point to a company that’s spending more than it’s bringing in. A company like Apple for example has a P/S less than 10.
This is a great way to evaluate growth stocks, especially following a major economic event like the coronavirus. Here’s what you need to look for in this value metric.
What Does Low Price to Sales Ratio Mean?
Companies with a low price-to-sales ratio are considered undervalued. This is a sign that the company is performing strongly and has a good chance of outperforming the general stock market. That means it’s a value for investors looking to buy in low to generate a profit, and the stock is likely to outperform analyst estimates.
We saw this happen in 2020 with AutoNation, Inc. (NYSE:AN) – the company dropped to a market capitalization well below $2 billion in the aftermath of the coronavirus pandemic.
It was assumed the company would suffer from shrinking marketing budgets from car dealers, but it still topped estimates by an average of 160.83 percent over the first half of 2020.
It was expected to only earn $0.36 per share and reported a surprise earnings of $1.41 per share, a nearly 300 percent increase.
The company generated $4.533 billion in sales for the second quarter of 2020, down 15 percent from the $5.343 billion in earned in the same period of 2019. Still, these sales mean the company has a low P/S ratio, even at its current market cap over $5 billion.
Now, let’s examine the other end of the spectrum.
What Does a Higher Price to Sales Ratio Mean?
The higher a price-to-sales ratio gets, the more money investors are spending to gain a return on investment.
Heading over $1 isn’t necessarily a bad sign, but a P/S ratio over 10 may be a red flag that the company may be selling for more than it’s bringing in. This is common with newer companies that are serving smaller markets, but it also happens with established companies. For example, Tesla is trading at a P/S ratio of 15 at the time of our research.
Overvalued companies will often have higher price-to-sales ratios, especially when they’re not making any sales. This is why earnings reports are so impactful on a stock’s price.
Of course, the industry a company is operating in makes a difference as to what a good price-to-sales ratio is, and you’ll need to evaluate the company against others like it to get the bigger picture.
You’ll also need to understand more about the company’s overall financials, because debt and overhead expenses can quickly wipe out profits from sales.
High P/S vs Low P/S Stocks: What’s the Difference?
Price-to-sales ratio is just one way to valuate a company, and it doesn’t show the big picture – it’s just one indicator.
A savvy investor takes every factor into account, by understanding the company’s P/S, along with its financial statements.
These are released every quarter and year, showing more detail in the company’s income and expenditures. This includes how much debt is on its balance sheets, as payments need to be made that include interest.
It’s possible to see companies with a low P/S that are entering into bankruptcy because there’s something else killing the business. This indicator just gives you an idea of what you’re looking at.
The biggest difference in the P/S ratio is that it helps you see where the sales are in an industry. If you’re looking to invest in an industry but don’t know which company to choose, this can tell you which ones the look at first. The lower the P/S ratio, the more likely the company is undervalued. But by looking under the hood you can assess whether the low ratio is due to problems lurking within the business operations.
Is Higher Price to Sales Ratio Better? The Bottom Line
Price-to-sales ratio is one of the most popular ways of evaluating a company’s fair market value. With companies like Netflix, Boeing, and Marriott being rated on different things, you’d need to compare P/S values for companies in the same industry.
The lower P/S ratios represent investors paying less for higher sales, but that’s not always a value. Companies with a low P/S ratio can still end up bankrupt due to other factors.
Still, P/S ratio is an effective way to determine which of your investments (or potential investments) are undervalued or overvalued. The higher the P/S ratio, the bigger the risk you’re buying in at too high a price.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.