How to calculate it, what it tells you, and how to use it↓
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 metric... the price to sales ratio.
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, or to its own historical ratio, to find out whether the firm is under, or overvalued.
This metric is exactly what it sounds like, price divided by sales. 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.
Let's use Apple as an example. Apple's current share price is right at $160. And we see their TTM revenue is 223,507 while their TTM shares outstanding equals 5,304.
To obtain Apple's P/S ratio divide share price by sales per share:
=> 160 / (223,507 / 5,304) = 3.80
One of the great things about the P/S ratio is that it looks at sales rather than earnings. This is beneficial in 2 ways in particular. One is you don't have to deal with the accounting tricks and manipulation that comes with earnings, one of the shortcomings of the P/E ratio. And two, you can value companies who aren't currently profitable rather efficiently. There are 3 primary instances where the P/S ratio comes in handy:
While there is probably no screener out there the P/S ratio wouldn't make better, there are a few drawbacks the investor should be wary of. For starters, sales don't always translate to earnings. While you can certainly use P/S instead of P/E in certain instances, all things being equal you should definitely choose the company with higher margins. Which is why gross and net margins should always be viewed with P/S. For instance, if company A and company B each have similar P/S ratios, but company A has 40% and 15% gross and net margins, respectively, while company B has 10% and 5%, company A should be the obvious choice. I only bring this up because companies with increasing profitability margins will tend to have higher P/S ratios.
Secondly, low P/S ratios often accompany firms with increasing debt. This is due to the sales being converted into paying off debt rather than the bottom line. This ultimately hurts the shareholder because sales and share price are not decreasing while the company may be inching closer and closer to bankruptcy. In instances where debt is a factor you would be better off using Enterprise Value to Sales, or EV/S, since this metric incorporates long-term debt into the numerator.
Even with its limitations, the P/S ratio has proven to be a formidable valuation tool in the long run. James O'Shaughnessey, money manager and author of What Works on Wall Street, performed a study stretching from 1951 to 2003 and found the P/S ratio to be the most consistent and best valuation metric available. His low P/S stock basket ended up beating the market in 88% of the rolling 10-yr periods. The next closest... P/B ratio, which beat the market in 72% of rolling periods.
In my opinion, the best way to use the P/S ratio is in a stock screener that includes gross and net margins as well as current and debt to equity ratios. We've seen that P/S is a fairly reliable and consistent predictor of value, but since it tends to lean towards less profitable, debt-holding companies, we need to include metrics that warn us of these potential traps. Any P/S under 3 is generally acceptable to me. Depending on the type of company, I may go over 4 but it has to be great firm with great management.
Another great way to incorporate the P/S ratio is by utilizing it in as an intrinsic valuation method... with the Median P/S technique. Simply take the company's 5 year P/S average and multiply it by its current sales per share. In Apple's case it would look like this:
(223,507 / 5,304) * 3.1 = $130.63
While I wouldn't use this as the only number, it certainly tells you a decent amount about the company's current valuation. According to Apple's 5 year average price to sales ratio, the share price should be trading somewhere around $130 rather than the current $160.