Markets

Key Metrics: Price to Sales

Today I want to take an in-depth look at what James O'Shaughnessy, author of "What Works on Wall Street," found to be the best historical value metricAA AAAAA the price to sales ratio. I'll discuss how to calculate it, what it tells us and how you can incorporate the metric in your investing approach.

What is price to sales?

The price-to-sales ratio, or P/S, is one of the most basic ratios out there. It's also considered a relative valuation metric since you need to compare one company's with another's, or to its own historical ratio, to find out whether the firm is undervalued or overvalued.

?format=1000w

This metric is exactly what is sounds like, price divided by sales AAA or more precisely price divided by sales per share. In other words, what you're paying for every $1 of sales the company makes. A P/S ratio of 2 means you're paying $2 for every $1 of sales while a P/S of 0.5 means you're paying 50 cents for every $1 of sales.

Calculation AAA Let's use Apple ( AAPL ) as an example. Apple's current share price is right at $100. And we see its TTM revenue is 227,535 while its TTM shares outstanding equals 5,648.

  • To obtain Apple's P/S ratio divide share price by sales per share.
    • 100 / (227,535 / 5,648) = 2.48 .

What did the P/S ratio reveal?

One of the great things about the P/S ratio is that it looks at sales rather than earnings. This is beneficial in two ways. One is you don't have to deal with the accounting tricks and manipulation that come with earnings, one of the shortcomings of the P/E ratio. And two, you can value companies that aren't currently profitable rather efficiently. There are three primary instances where the P/S ratio comes in handy:

  1. Cyclical companies AAA In cyclical industries, there are often years when only a few companies are able to turn a profit. In these instances the P/S ratio is useful in determining value. An increased P/S can warn the investor of overvaluation while a decreasing number may point to a recovery.
  2. Growth companies experiencing temporary setbacks AAA Growth stocks are notoriously tough to value since earnings are often spotty at best. Just look at Amazon ( AMZN ) as an example. It seems it can turn a profit at the flip of a switch but is often reinvesting so much that it makes it hard to be consistent. In this instance you can use the P/S figure as a valuation tool.
  3. Turnarounds AAA With turnarounds earnings are almost never present, hence the name. However, as is the case with cyclical companies, a decreasing P/S ratio may indicate a rally is near.
?format=500w

While there is probably no screener out there the P/S ratio wouldn't make better, there are a few drawbacks of which the investor should be wary. For starters, sales don't always translate to earnings. While you can certainly use P/S instead of P/E in

PHM 15-Year Financial Data

The intrinsic value of PHM

Peter Lynch Chart of PHM

Warning! GuruFocus has detected 4 Warning Sign with ABT. Click here to check it out.

ABT 15-Year Financial Data

The intrinsic value of ABT

Peter Lynch Chart of ABT

Warning! GuruFocus has detected 3 Warning Sign with AAPL. Click here to check it out.

AAPL 15-Year Financial Data

The intrinsic value of AAPL

Peter Lynch Chart of AAPL

Warning! GuruFocus has detected 8 Warning Signs with KO. Click here to check it out.

KO 15-Year Financial Data

The intrinsic value of KO

Peter Lynch Chart of KO

Warning! GuruFocus has detected 3 Warning Sign with AAPL. Click here to check it out.

AAPL 15-Year Financial Data

The intrinsic value of AAPL

Peter Lynch Chart of AAPL

Read More:

About GuruFocus: GuruFocus.com tracks the stocks picks and portfolio holdings of the world's best investors. This value investing site offers stock screeners and valuation tools. And publishes daily articles tracking the latest moves of the world's best investors. GuruFocus also provides promising stock ideas in 3 monthly newsletters sent to Premium Members .

This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

AMZN AAPL

Other Topics

Stocks