The two most famous metrics to analyze stocks are the P/E ratio and the dividend yield. However, the Price-to-Sales Ratio is key to analyze many types of companies. It can also help us identify if there is a stock market bubble.
Content
- Introduction
- How to calculate the Price-to-Sales Ratio
- How to use the Price-to-Sales Ratio
- How to Identify Stock Market Bubbles
Introduction
The price-to-sales ratio of a stock allows us to compare the valuation of a company with its total revenue. Essentially, it indicates how many times its annual revenue a company is worth.
There are several reasons why it is very useful to look at the price-to-sales ratio. It can be used both to analyze individual stocks, as well as entire sectors or stock markets, to assess if they are undervalued, overvalues or fairly valued.
It is also a very useful metric to analyze companies that are growing fast and not yet achieving significant profits.
How to calculate the Price-to-Sales Ratio
The price-to-sales ratio can be calculated by dividing the stock price of a company by the revenue per share. A ratio of 1 means that the price of a stock is equal to the revenue per share. It also means the market capitalization of the company is equivalent to the total revenue within a year.
Let us use Apple in mid-2020 as an example:
- Price per share (June 26th, 2020): $353.63
- Revenue per share (FY 2019): $60.03
- Price-to-sales ratio = 353.63 / 60.03 = 5.89
We can calculate the same ratio using the market capitalization and the total revenue:
- Market capitalization (June 26th, 2020): $1.533 trillion
- Total revenue (FY 2019): $260.174 billion
- Price-to-sales ratio = 1,533,000 / 260,174 = 5.89
As you can see, both formulas will yield the same result. In this case, Apple’s price-to-sales ratio in mid-2020 was just below 6.
Determining whether this ratio is high or low is trickier than calculating it. A useful thing is to look at a company’s past price-to sales ratio. For example, at the end of 2015, Apple’s ratio was 2.74. In the subsequent 4 and a half years, annual revenue grew by 11%, but the stock went up by 140%. That “disconnect” pushed the price-to-sales ratio higher.
This could potentially mean that, at least compared with its own historical valuations, Apple was trading at expensive levels in mid-2020.
How to use the Price-to-Sales Ratio
Let us discuss in which situations it is most useful to observe the price-to-sales ratio.
High-growth Companies
One of the great applications of the P/S ratio is to evaluate companies with very high growth rates. Often, these companies have very low or no profits at all. The lack of profits can usually be explained by the company focusing more on growing rather than running the business profitably.
In other words, the goal is not to make short-term profits. The goal is to achieve a considerable size that makes it possible to achieve high profits in the future.
Because the P/E ratio is useless to analyze these companies, the P/S ratio tells us what the potential of this company is.
For example, imagine a company with no profits and a P/S ratio of 10. If we know the profit margin of more consolidated companies in the sector and how the company will grow in the future, we can estimate future profits.
Mature Companies without Profits
Mature companies can also have low or no profits, especially in times of economic recession or changes in the industry. But things can improve in the future.
These companies can also be analyzed with the price-to-sales ratio. We can compare the current ratio of a company with the ratio of other similar but profitable companies in the industry, or with the company’s own historical P/S ratios.
The objective in this case is to have a reference point from which to value the company. Since profits have to come from revenue, the P/S is indicative of the future potential for such companies.
How to Identify Stock Market Bubbles
Another reason why the P/S ratio is so useful is because it can be used to analyze whether a single stock or the entire stock market is in a bubble. Or, conversely, if prices are too low and a rally is imminent.
While the P/E ratio is generally useful, profits can increase temporarily and exceptionally without being justified by either a company’s or the economy’s fundamentals. This occurs when profit margins suddenly increase. This could happen ahead of an inflationary wave.
However, and although there are some exceptions, it is rare for a company to be so dominant in its sector to be able to increase margins permanently. And the same thing can be said about the entire corporate sector.
In times of abnormally high corporate profits, even if stock prices were to rise, the P/E ratio would probably not indicate that there is a bubble, since it would look artificially low due to the high level of profits.
However, the P/S ratio can be very handy in such a situation. Revenues allow us to discern if a company’s business has really grown and a higher stock price is justified, or if we are just experiencing a temporary spike in profits.
The same logic can be applied to the stock market in general. For this purpose, we can analyze the P/S ratio of the entire stock index. Since revenues are much more stable than profits, if the P/S ratio shoots up dramatically without the P/E ratio rising much, there is a high probability that we may be in a bubble. And bubbles tend to crash eventually.
Similarly, profits fall much more sharply than revenues when there is a recession. This makes the P/E ratio less useful. In those circumstances as well, the P/S ratio may indicate that the stock market is undervalued and due to a rebound.
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And if you want to learn about the P/E ratio itself, check out the following link:
The Price-to-Earnings (P/E) Ratio – How to Use It
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