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.
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:
- 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.
- 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.
- 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.
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
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