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Importance of Price-Sales Ratio to Value Companies

We can see that price-to-sales is the most popular valuation ratio used on YCharts.

That is because the P/S ratio is easy to calculate by a stock trading and can be used for companies with a wide range of earnings and cash flow profiles.

P/S is also a very useful valuation ratio for high growth companies. Many high growth companies do not have positive earnings or cash flow in their early years.

P/S does not require earnings, so it can be applied to young companies as well as more established businesses.

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What is a Price-Sales Ratio?

Price-to-sales ratio (P/S) is the ratio of a company’s stock price to its sales per share. It is calculated as market capitalization divided by the revenue per share.

The price-sales ratio is similar to the price-earnings ratio in that it helps investors determine whether a stock is undervalued or overvalued.

The P/S ratio can be used with any type of company, but it is most commonly applied to those companies that are not profitable or whose profits are not consistent.

The P/S metric does not consider whether a company is earning a profit, only how much revenue it generates for each share outstanding.

Because profit margins vary widely across industries, the price-sales ratio does not always provide a meaningful comparison between companies in different sectors.

 

Also read – Is It Good To Buy Low P/E Ratio Stocks?

 

There are Several Determinants of the P/S Ratio and They are:

  1. Growth Rate: companies with a high growth rate will have a higher P/S ratio
  2. Industry Norms: different industries have different norms for P/S ratio, so an industry average is important
  3. Profitability: if the company is unprofitable, then there will not be any sales to get a ratio for, so it does not make sense to use this method in that case

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What is the Importance of Price-sales Ratio While Valuing Companies?

Price-Sales Ratio is a ratio of Price per share / Sales per share. For ex: Price per share = ₹100, Sales per share = ₹200 then the price-sales ratio = 100/200 = ₹0.5 which means that for every rupee in sales, the company’s market value is 50 paisa.

This ratio gives us the value of a company per share in terms of sales.

When comparing companies from different industries, it is important to compare their price sales ratios within their respective industry group.

Because different industries have different profitability and capital structures.

P/S ratio for typical technology companies tends to be higher than for other types of companies because investors are willing to pay more for growth.

The P/S ratio is also useful in comparing two companies that are growing at different rates because the P/S ratio will adjust accordingly and make them easy to compare.

Know all about stock market trading.

The PSR Ratio has Some Drawbacks:

  1. It cannot be used as a tool to compare companies across different industries as each industry has its own norms and average P/S ratios.

For example, software companies normally have high P/S ratios compared to manufacturing companies due to higher margins in the former and lower margins in the latter.

  1. It cannot be used alone as a valuation tool and should only be used in combination with other valuation metrics such as EV/EBITDA (earnings before interest, taxes, depreciation, and amortization), EV/Sales etc.
  2. Since accounting practices differ from country to country, the country-specific price-sales ratios should be used for comparison instead of comparing global/pan-industry.

 

What is a Good P/S Ratio?

A price-to-sales ratio is a company’s share price divided by the company’s revenue per share. It compares a company’s stock price to the total revenue of the business.

If a company’s P/S ratio is between 1 and 2, it is considered to be a good investment. However, a P/S ratio of less than 1 is considered excellent.

For example, imagine that Company A has a P/S ratio of five, while Company B has a P/S ratio of 10.

You can conclude that investors expect Company B to grow faster than Company A. This makes sense, because investors expect to pay more for future earnings growth.

Also, read – about intraday trading

Difference Between PE Ratio and P/S Ratio

The P/S ratio is the Price to Sales Ratio. The price/Sales ratio (PS ratio) for a sector is calculated by taking the sum of the market capitalization of all the stocks in the sector and then dividing it by their aggregate sales.

Higher the ratio, the more expensive the sector. Lower the ratio, the cheaper the sector.

The price/Earnings (PE) Ratio for a sector is calculated by dividing the total market capitalization of all the stocks in that sector by its total earnings.

If a company has a PE ratio of 25, it means investors are willing to pay ₹25 for every rupee of its earnings.

The higher the ratio, the higher is the risk associated with that company’s stock. The lower the PE ratio, the lower is the risk associated with that stock.

Conclusion

It can be concluded that there are many advantages and disadvantages to valuing companies, it depends on the companies.

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