17-Nov-2005

>Why and How use the Price/Sales Ratio?

P/S Ratio = Market cap (shares outstanding * market price per share)/Total sales

Total sales can be found at the top of the income statement. Some companies will list total sales (also called revenues) on the first line, while others will list revenues from different business segments first and then add them to get total sales. Some companies will use "net sales" instead of total sales, which is arrived at by subtracting cash discounts, goods returned for credit, and other allowances. It is fine to use net sales in calculating the P/S ratio.

While not quite as useful as the P/E and the P/BV ratio as a valuation measure, the price-to-sales ratio (P/S)
comes in quite handy when

=>evaluating unprofitable companies, which do not have a P/E ratio.
=>P/S ratio can also be used to compare firms within an industry.

=>For value investors, a P/S ratio lower than 1.0 often indicates an opportunity,
but it's critical to properly account for sales, debt, different costs, and profit margins across firms. The ideal situation for us would be a company with a low P/S multiple and a relatively high profit margin.

=> Unlike the P/E and P/B ratios, the P/S ratio doesn't involve accounting estimates that can be used by the company to inflate, or even deflate, earnings. That said, companies can still manipulate sales, so we must look carefully at how a company records its revenues.

=>For cyclical companies and turnarounds, we cannot use the P/E ratio when earnings are negative. But as long as the company is not headed for bankruptcy, we can use the P/S ratio to track what the market is willing to pay for its sales. If the company's P/S ratio is much lower than others in its industry, it may indicate a value opportunity. For young companies yet to make a profit, we often look for high sales growth, which we hope will translate into net earnings and, ultimately, free cash flow. The P/S ratio tells us how much the market is paying for sales and gives some indication of value.

=>Some investors consider a relatively low P/S ratio with a rising stock price (high relative strength) to be a good basis to invest in growth stocks that have suffered a temporary setback.

=>As with P/E and P/B, the P/S ratio can help compare a stable company's current value to its past valuations. If the current P/S ratio is less than the 10-year average, it may indicate a value.

P/S under the microscope
1. Just as the
P/E ratio should be considered with earnings growth and the P/B ratio with return on equity, the P/S ratio should be considered in tandem with net margin (also called net profit margin, it's net income divided by total sales).

2. A company can book sales for which it has not yet provided the goods or services, or before a customer is obligated to pay. This is called channel stuffing and leads to inflated sales and earnings, and consequently, lower P/S and P/E ratios. Another warning would be declining cash flows from operations on the cash flow statement even as net earnings rise.

3. Generally a company with higher debt will have a lower P/S ratio, because some of those sales, when converted to cash, have to go toward debt interest and paying down debt -- not to equity holders. When comparing companies with significantly different debt loads, it's best to compare enterprise value-to-sales (enterprise value = market capitalization + debt - cash).

4. A company that earns commissions on total sales may book total sales on its income statement instead of commissions, thereby drastically lowering the P/S ratio. This is perfectly legitimate, but it distorts the P/S ratio.

That's just a
brief look at the P/S ratio, and I've only touched on a few of the wrinkles associated with it. As a measure of value, P/S is particularly useful for a young growing company, or a company without any earnings, but as with other valuation metrics, it should not be used in isolation.

========== on a different note ========>

Alfred Rappaport, an accounting profes­sor at the Kellogg Graduate School of Management at Northwest­ern University, published a series of articles that pointed out that cash-flow analysis not only was a better predictor of the value of a business enterprise but also could forecast future stock market price levels more accurately.

1 comment:

Dhanan - equity analyst said...

Good blog Rajeev. Interesting stuff. It can be taken as substitute of EV/Sales ratio. In my opinion, i think debt should be excluded to find out the real value of biz and its volume of operation. P/Sales brings out the actual size of the biz and market perception abt it.