Key Takeaways
- The price to sales ratio is also known as sales multiple or revenue multiple
- It describes the value of the dollar amount of the said company’s revenues or sales by financial markets.
- price to sales ratio helps provide company valuation based on the operations and business processes of a company
- The ratio must always be used in the comparison between companies operating in the same industry rather than across different industries
What is Price to Sales Ratio?
It is also known as sales multiple or revenue multiple. It is used for the valuation of a company or organizations’ stock price to its revenues. It describes the value of the dollar amount of the said company’s revenues or sales by financial markets.
It was introduced by Kenneth Fisher who noticed that investors would place unreasonable valuations on the company – resorting to panic selling stocks if the value of the company dropped below their expectations. With the introduction of this ratio, the problem of over-valuation was rectified because the formula used sales as its basis which remain stable instead of earnings which fluctuate.
How to calculate Price to Sales Ratio
The following formula illustrates how to calculate the P/S ratio:
Price to Sales Ratio: Stock Price / Total Sales
The value for total sales is available in the company’s income statement and share price can be found either in the income statement or the company’s financial document.
Understanding P/S Ratio
It helps investors and analysts understand how much they’re actually paying for the company – making it one of the most convenient ways to understand the company’s valuation. Since generating revenue and profits is the main purpose of any business, the price to sales ratio helps provide company valuation based on the operations and business processes of a company without making adjustments related to accounting.
The ratio also benefits startups and infant companies who are yet to generate income by placing a valuation on their available assets. A lower P/S ratio indicates that the company is being undervalued and is considered to be optimal. However, in order to reap maximum understanding, it is important to examine the ratio from the overall industry’s perspective and keep an eye on its historical trends.
Like any other financial metric, price to sales ratio comes with some limitations as well and must always be used in the comparison between companies operating in the same industry rather than across different industries. P/S ration also does not in itself provide information regarding costs or profitability of a company. To make sense of it, it is therefore important for analysts and investors to see it in conjunction with other financial ratios.
