Also a financial metric, the price to sales ratio is used to measure the value that the investors put on a certain company for each dollar of revenue that’s being generated by the said company. This is done by comparing the stock price with the total revenue of the business.
The price to sales ratio is commonly used, as it shows the value of a company in relation to one of the most common and easiest to understand metric, namely, the revenue.
Understanding the Price to Sales Ratio
When used by investors, the price to sales ratio is one of the easiest and most basic valuation ratios. Basically, all they want to know is just how much they have to pay for a certain company – and the final result/ answer must come in a very basic and clear form.
After all, a company is based on selling goods and services and generating revenue from doing this – therefore, the price to sales ratio determines the value of a certain company based only on its actual operations, not taking into account any accounting adjustments.
Moreover, the price to sales ratio is also quite useful when it comes to start-up companies which have a zero or negative net income.
If this ratio is low/ lower, it is a good sign as this might indicate that the company is being under evaluated. Of course, the price to sales ratio must be looked at from an industry, historical, and investor expectation point of view.
Naturally, the investor’s expectation is the variable that changes the most when looking at this type of ratio, because his or her expectations are based on the share price movement as well, and not only on the variables within a certain company.
The Formula of Price to Sales
If we want to calculate the Price to Sales ratio, all we have to do is divide the market value price per share by the earnings per share. The total sales of a company can be found on its income statement and the number of shares outstanding on the notes to accounts of a certain annual report – the latter may also be found on the income statement.
In case we decide to use the total market cap in the equation as a numerator, then the denominator should be the total sales. On the other hand, is we use the share price as a numerator, then the denominator should be the sales per share.
The price or market cap is, as you probably know, stock market information and, therefore, it changes every single day. That’s why the Price to Sales ratio, which is a valuation ratio, must be time stamped. In general, the Price to Sales ratio is used to compare a company’s current status with its own history, and within the same industry, of course. The cases in which this ratio is used to compare across different industries are rare.
Given this ratio’s intuitive explanatory capabilities, it is commonly used in most industries out there.