Price to sales ratio is similar to Price-Earnings (PE) Ratio with sales forming the denominator instead of earnings. Comparing price to sales ratio is generally useful only when comparing companies which belong to similar industries.
Price to Sales ratio = Company’s market capitalization / Company’s total sales
PRICE = company’s market capitalization (the number of shares * Market price per share)
SALES = company’s total sales over the past 12 months.
Also Read: Market Capitalization
Lower P/S ratio indicates that total sales is that much higher in comparison to the market capitalization of company.
If P/S ratio is 1, it means you are paying Rs. 1 for every Rs. 1 of sales that the company makes
If P/S ratio is 2, that means you are paying Rs. 2 rupees for every Rs. 2 of sales that company makes
if P/S ratio is 0.5, that means you are paying 50 paisa for every Rs. 1 sales that the company makes
Why P/S Ratio
- Price to Sales ratio is helpful in identifying cyclical companies (companies having seasonal sales)
- The ratio helps in identifying whether companies maintain higher margins or higher volumes on an industry wide basis.
Example – let’s compare grocery stores with the medical-device industry. Grocery stores tend to have very small profit margins, earning only a few pennies on each Rupee of sales. As such, grocers have an average P/S ratio of 0.5, one of the lowest among other industries P/S Ratio.
It takes a lot of sales to create a rupee of earnings at a grocery store hence investors do not value those sales very highly. Meanwhile, medical-device makers have much fatter profit margins. Relative to the grocer, it does not take nearly as much in sales for a medical-device company to create a dollar in earnings. It is little wonder the device makers have a high average price/sales ratio of 5.0.
Case Study – Dabur India Ltd.
|Years||Market Capitalization (In Rs. Cr.)||% change||Sales (In Rs. Cr.)||% change||Price to Sales Ratio||Correlation|
Explanation – If market forces are kept aside and strictly in a efficient market scenario, for a company with a correlation of 0.91 – a 10% change in sales should have an impact of 9.1% on the stock price.
Written by: Puneet Singh