Understanding the Price-to-Sales Ratio

When a company sells a product or service, investors and analysts sometimes have the following question: How much in terms of the company’s stock price is each dollar of revenue worth? To answer, they sometimes use a measure called the price-to-sales ratio, or P/S ratio. The financial ratio has a number of similarities to the better-known price-to-earnings ratio, or P/E. But it tells a different story, especially for companies that are young or unprofitable.

What is a price-to-sales ratio?

A price-to-sales ratio measures the valuation the stock market puts on every dollar of a company ’s sales or revenue. Investment advisor Ken Fisher developed the ratio as another way of valuing a company, noting that sales or revenue are straightforward and more stable, while earnings can be skewed by accounting adjustments, such as depreciation, accruals, and deferrals.

The P/S ratio is sometimes used as an alternative valuation measure to the P/E ratio, and it is expressed in much the same way. For example, just as a price-to-earnings ratio of 15 tells investors the stock price is 15 times earnings, a price-to-sales ratio of 5, for example, would indicate the stock is trading at five times the company’s sales.

How the price-sales ratio works

A price-to-sales ratio can be computed in one of two ways: 

1. Take the company’s total market capitalization and divide by its sales or revenue for the latest year or trailing 12 months.
2. Take the stock price and divide by sales or revenue per share. Sales per share is obtained in the same way as earnings per share, by dividing the total sales by the number of shares outstanding.

Either calculation should produce the same result for the P/S ratio.

Price-to-sales example

Consider a hypothetical company, Widget Corp., with 100 million shares outstanding and a share price of $120. Widget’s market cap, or the total market value of its shares, is:

                      100 million x $120 = $12 billion

If annual sales were $3 billion, then Widget’s P/S ratio is:

                        $12 billion/$3 billion = 4

In other words, at the current stock price, investors are paying $4 for $1 of Widget’s sales. All things being equal, a lower ratio would suggest that an investor is getting more bang for their buck.

At the same time Widget has annual sales of $3 billion, it has earnings of $1 billion. Based on the company’s $12 billion market value, the P/E ratio would be:

‍
                      $12 billion/$1 billion = 12

A real example will further illustrate. IBM had a market cap of $119.7 billion at the end of 2021, and its revenue for the year was $57.4 billion. Its P/S ratio at year-end was:

                      $119.70 billion/$57.40 billion = 2.09

Interpreting results of the the price-to-sales ratio

How do investors interpret the ratio? Can it be used to evaluate whether the stock is cheap, or expensive?

Let’s start by considering the example above of Widget Corp., with a P/S ratio of 4.

The ratio can’t be interpreted in a vacuum. It must be compared against similar companies’ price-to-sales ratios, against the average for the company’s industry or sector, or against broad market benchmarks. For example, the average P/S ratio among companies in the S&P 500 Index rose above 3 in 2021 (a record), before declining to about 2.5 in mid-2022. So in this hypothetical case, shares of Widget would be more expensive than the broader stock market.

Investors also compare a company’s historical price-to-sales ratio against the current reading. Has it been rising or falling? A high ratio relative to past levels might suggest the company’s shares are overvalued. This would be the case if Widget’s historical average was a P/S of 3.

Now let’s imagine that Widget’s competitors have an average P/S ratio of 4.8, meaning it costs on average $4.80 to buy $1 of the competitors’ sales, based on their stock prices. Widget’s stock price seems inexpensive, then, based on its ratio of 4.

In the real world, price-sales ratios vary widely, among industries and sectors. A study of more than 7,000 industries and sectors in the U.S. by New York University’s Stern School of Business showed several industries with ratios below 1, such as big retailers and supermarkets, while software developers had ratios ranging from 12 to 17, making them among the most expensive stocks relative to their sales or revenue, as of the end of 2021.

How the price-to-sales ratio is useful

The price-to-sales ratio can be an alternative valuation method if a company isn’t yet profitable and therefore a P/E ratio can’t be calculated.

For this reason, so-called growth stocks, which often are not profitable, are sometimes compared on the basis of P/S. Amazon and Netflix are two good examples. Analysts for several years focused on their sales growth and price-to-sales ratios until they started to turn a profit in the early 2000s. In the absence of earnings or positive cash flow, the P/S metric may be necessary.Examining the price-to-sales ratio may also help investors determine if a growth company is becoming overvalued—the stock gets too expensive relative to its sales growth. The P/S ratio can also help in the search for possible turnaround opportunities among companies that hit a rough patch in earnings but still have strong sales.Industries that tend to rise or fall with the economic cycle, sometimes losing money, also may get more price-to-sales scrutiny. The ratio can show which companies have strong sales relative to their stock price while they await an economic rebound and a return to profitability. Industries in durable goods such as heavy machinery may sometimes warrant price-to-sales evaluations. So do industries dependent on discretionary spending by consumers, such as airlines, cruise-ship operators, and luxury-goods makers.

Limitations of the price-sales metric

Comparing sales-price ratios across industries may not be suitable. For example, it probably makes little sense to compare Microsoft’s P/S ratio with that of Walmart’s, because a software company has a very different business model from a retailer.

Also, many companies have more than one line of business, or are in different industries or sectors, making P/S comparisons less meaningful. IBM is a good example. It still makes mainframe computers, but it now is a leading provider of office-network services and systems, competing in the cloud data-storage business. Comparisons with other companies will depend on which IBM business segment is examined.

Because companies can change over time, sometimes shifting into different industries, analysts and fund managers often must rethink their peer-grouping of companies to keep their ratio comparisons appropriate.

Investors can appreciate the simplicity of the P/S ratio, as they do for the P/E ratio. Still, the P/S ratio has clear limitations: It’s only about a company’s sales, not profit or cash flow. Price-to-sales isn’t enough for most investors in the long run; eventually they expect a company to report a profit.

Further, the price-to-sales ratio ignores debt. A company with a P/S ratio of 3 and a heavy debt burden is different from a debt-free competitor with the same ratio. The latter doesn’t have interest costs and the burden of eventually repaying the debt. Investors might be more attracted to the debt-free competitor with a similar price-to-sales ratio.

Another ratio called the EV-to-sales ratio may provide more insight. This uses a company's enterprise value (EV), which adds debt outstanding and then subtracts accumulated cash from the market cap. In the case of the two hypothetical companies above, the company with debt and a higher enterprise value might end up with an EV/S ratio of 4, making it look more expensive versus the debt-free company, which would have an EV/S ratio of 3.

The bottom line

The price-to-sales ratio can be useful in evaluating whether a company’s stock is cheap or expensive, relative to the amount of sales or revenue the company generates. It can be especially helpful to evaluate a stock if a company isn’t yet profitable.But a P/S ratio is not always useful if viewed in isolation. The ratio should be examined in conjunction with other ratios or measures of a company’s operating performance, as well as compared with other companies like it or in the same industry.