Price-to-sales ratio

Published: Aug 2009

The price-to-sales ratio (PSR) measures the relationship between the value of stock and the level of sales a company is experiencing as a result of its operating activities. It provides a useful way to compare a company’s activity with both its competitors and its own past performance.

The PSR is calculated by dividing the individual share price by the annual revenue per share. The formula is as follows:

$$\mathrm{PSR}=\frac{Share\: price}{Revenue\: per \:share}$$

For example, if the company’s share price was $40 and the revenue per share was$32, the PSR would be 40/32 = 1.25.

PSR can also be calculated by using the following alternative formula:

$$\mathrm{PSR}=\frac{Market\: cap}{Annual\: revenue}$$

Market cap

Market cap (capitalisation) is the share price multiplied by the number of shares outstanding. It shows the market value of a company’s equity.

What is it used for?

PSR shows investors the value of their investment. Theoretically, if a company’s PSR is high, it shows that investors are paying more for the company’s sales than if the PSR were low. Therefore a low PSR traditionally signifies better value. However revenue is not the same as profit – nor the same as cash flow – so PSR is just one measure that helps investors know when the price of stocks is right for them.

In the 1990s there was a spectacular growth in young internet companies with high sales but no profit and although this is now in the past, there are still a number of new companies with low or no earnings. Established companies may likewise experience periods where they produce no profits. Calculations which deal with earnings, such as EPS (earnings per share), cannot therefore be used to determine the value of these companies’ stocks. PSR is based on sales rather than on earnings, so it is ideal for calculating the value of a company with no earnings history. The underlying assumption is that profits will be made once market share is established.

PSR is sometimes seen as a more reliable performance indicator because sales statistics are harder to manipulate than earnings.

Problems with PSR

This particular ratio can be misleading because unlike earnings, sales figures do not take a company’s expenses or debt into account. It is possible for a company to have a low PSR as a result of its massive debt and/or lack of a profitable business model. In such cases a low PSR would not represent a bargain.

What is classed as a ‘normal’ PSR varies according to industry. When using PSR to compare companies, it is therefore important to remember that it may not give an accurate cross-industry picture and is best used when comparing similar companies.

As with most ratios, it is important to consider other relevant factors and alternative metrics when determining the value of a company’s shares.