Throwing light on price-sales ratio

The use of price multiples in the stock market has become indispensable for an investor. The famous one is the price-to-earnings multiple. There are other metrics too that can be used as a relative measure for the price of a stock. One of the widely used metrics is the sales of a company. Let’s study its advantages & limitations and compare it with P/E multiple.   

A glimpse of price multiples  

The basic idea behind using price multiples is that the price alone does not provide sufficient information. It can be evaluated in isolation. And thus, a relative comparison is made with earnings, sales, book value, etc. to make it sensible. For example, if a stock has a P/E multiple of 10, it simply means that you will have to pay Rs 10 to earn Re 1. The word ‘relative’ is important here.   

P/S ratio  

In recent times, the P/S ratio has become a popular valuation indicator in equity markets for many investors. Financial analysts have been using this ratio in their investment process. The Price-to-sales ratio is calculated as price per share divided by the annual net sales per share. Analysts mostly use the latest fiscal net sales for the calculation.  

Advantages  

The possibility of sales manipulation or distortion is lesser than for earnings or book value. For example, by transferring losses into other comprehensive income shown in ‘changes in equity’ statement, the earnings can be inflated. On the other hand, the net sales are less likely to be distorted.  

Also, earnings can be negative but sales cannot be. The P/E cannot be used when the company is facing net losses. In such times, P/S is a more meaningful tool to use.  

Sales are usually more stable than earnings. Less volatile multiples are beneficial for valuation purposes.  

As an analyst, getting a true picture of earnings can be difficult. However, net sales are straightforward numbers.  

Limitations  

A company might have strong sales but poor profits and cash flows. What ultimately matters is how much a company is actually making at the end of the day, which is reflected by earnings and cash flows.  

It fails to reflect different cost structures across companies. For example, for two similar companies, one might have a higher cost of goods sold than the other, which is not factored into P/S.  

To put it in a nutshell, all price multiples come with respective pros & cons. An investor must have knowledge of using multiples to come up with the best possible output. It is both, an art and science!