Price-to-Sales ratio

The P/E ratio needs profit. Plenty of companies have none worth measuring — they are young, turning around, or have only just broken even. Sales are never negative, so the price-to-sales ratio can be computed for almost any company.

It answers a plain question: for every rupee of revenue this company earns in a year, how many rupees is the market asking me to pay?

Section 3.1.12 gives the two equivalent forms and a rule of interpretation: all else held constant, a company with a lower P/S than its peers indicates the stock is relatively undervalued. But the company's future profit potential and its financial and other risks can earn it a premium or a discount, a drop in the revenue growth rate is a high risk for such stocks, and the ratio should be used with other data and compared with similar companies in the industry.

Chapter 10 (section 10.7.5) takes the same idea to the enterprise level. P/E, EV/EBITDA and EV/EBIT cannot be used when profit is negative, and are too high to be meaningful for a company that has only just broken even; EV/Sales is more meaningful there, because sales can never be negative. But it suits only companies likely to turn profitable and sustain it — if a turnaround is not likely, going concern is in doubt and the company should be valued at liquidation value.

The Chapter 13 checklist lists Price/Sales among the valuation parameters to compare against the company's own history, peers and the market over five years.

P/S ratio = Current market price ÷ Annual net sales per share
          = Market capitalisation ÷ Annual net sales

EV/Sales  = Enterprise value ÷ Annual net sales

The workbook's example. Annual net sales Rs 1 crore, 10 lakh shares, market price Rs 40.

Sales per share = 1,00,00,000 ÷ 10,00,000 = Rs 10
P/S             = 40 ÷ 10 = 4×

Two retailers — illustrative, Rs crore:

On P/S alone B costs twice as much per rupee of sales. Once B's Rs 3,000 crore of debt is counted, it costs three times as much. Whether either is cheap still depends on what margin each can eventually earn on those sales.

Chapter 3 (Terminology in Equity and Debt Markets) defines P/S with a worked example; Chapter 10 (Valuation Principles) explains when a sales multiple is the right tool — loss-making or just-profitable companies with a credible turnaround — and when it is not; Chapter 13 includes Price/Sales in the valuation checklist.

• Market cap pairs with sales per the P/S formula; EV pairs with sales in EV/Sales. P/S ignores debt, so it flatters a heavily borrowed company.
• Use net sales per share, not EPS. Mixing in EPS turns it into a P/E ratio.
• A low P/S is not a bargain by itself. Revenue that never converts into profit is worth little, and the workbook singles out a fall in revenue growth as a high risk.
• A sales multiple for a company with no plausible turnaround is the wrong tool — the workbook says such a company should be valued at liquidation value.
• Compare P/S within an industry. A software company and a grocery retailer earn very different margins on each rupee of sales.