Price/Sales (P/S) Ratios

(2 of 9)

Price/Sales (P/S) Ratios

One of the most basic valuation ratios is the P/S ratio. The P/S ratio is equal to a stock’s market price divided by its sales per share:

The nice thing about the P/S ratio is that sales are fairly cut-and-dried numbers, not subject to much accounting assumption and manipulation like earnings can be. Although firms could use accounting tricks to lift sales, it’s much harder to do and far easier to catch. Moreover, sales are not as volatile as earnings, because one-time charges or gains can depress or boost earnings temporarily. Plus, the bottom line of economically cyclical companies can vary significantly from year to year, but sales are a more stable benchmark. Moreover, the P/S ratio can be used for companies that don’t have positive earnings.

The value of using P/S ratios

The relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings by comparing their current P/S ratios with historic P/S ratios. The P/S ratio could also be a helpful tool in analyzing companies in the same industry, particularly when a firm may have unstable earnings or no earnings at all. By 2010, for example, AMR Corp (parent company of American Airlines at the time) had lost billions following the financial crisis and Great Recession, rendering its price-to-earnings multiple useless as a valuation technique. However, comparing United Airlines’ (UAL) P/S ratio of 0.1 with Southwest’s (LUV) of 0.8 appeared to reveal a substantial pricing discrepancy in the market. However, P/S ratios should be used with caution. In this example, further analysis would indicate that AMR was facing a liquidity crisis and headed to bankruptcy. Meanwhile, Southwest’s low-cost structure and fuel hedges allowed it to deliver operating profits for over 35 consecutive years.

Drawbacks of P/S ratios

Despite several advantages, the P/S ratio has some limitations. One major flaw is that sales may be worth a little or a lot, depending on a company’s profitability. If a company is posting billions in sales, but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio on the shares because we have no idea what level of profits (if any) the company will generate.

We will reiterate that when using the P/S ratio, it is important to keep in mind that a dollar of earnings has the same value regardless of the level of sales needed to create that dollar. A dollar of sales at a highly profitable firm is therefore worth more than a dollar of sales for a company with a narrower profit margin. Thus, the P/S ratio is generally useful only when comparing firms within an industry or industries with similar profitability levels, or when looking at a single firm over time.