Stock prices are influenced by various external and internal factors like demand and supply of the stock, macroeconomic conditions, etc. Therefore, the price at which the stock is trading on exchanges may not be fair. Chances are the stock is undervalued or overvalued. When you pay a fair price or lower for a stock, it can give you a better return on investment. Conversely, an overvalued stock can give relatively lesser returns. There are several ways to evaluate whether a stock is fairly priced, undervalued or overvalued. One of them is by using the price-to-sales ratio.
In this article, learn about the price-to-sales ratio, its calculation, importance and limitations.
Price to Sales (PS Ratio) Meaning
The Price-to-Sales (P/S) ratio is a valuation metric that compares a company’s market capitalisation to its total revenue. The P/S ratio provides insights into how much investors are willing to pay for each unit of a company’s sales and identify whether it is an undervalued or overvalued stock in the market.
How to Calculate P/S Ratio?
There are two formulas that can be used to calculate the price-to-sales ratio, and you can use any one of them:
- • Price to Sales Ratio = Market Capitalisation / Annual Revenue Or
- • Price to Sales Ratio = Latest Closing Share Price / Revenue Per Share
To calculate the P/S ratio, follow these steps:
- Determine the company’s market capitalisation: This can be calculated by multiplying the company’s current stock price by its total outstanding shares.
- Get the company’s total revenue: This information can be found in the company’s financial statements.
If you are using the other formula, you will need the last closing price of the stock and the revenue per share.
Now use the formula to get the P/S ratio. A higher ratio means that investors are paying a high price when considering the company’s sales, while a lower P/S ratio indicates that the company is undervalued when compared to its sales.
Read More Types of Ratio Analysis
Examples of the Price-to-Sales Ratio
Let us consider an example to understand how to use the price-to-sales ratio better. Suppose XYZ Company has a total revenue of Rs. 1,50,000, and the current market cap of the company is Rs. 5,00,000. In that case, the P/S ratio of the company is:
P/S Ratio = Market Capitalisation / Total Revenue
P/S Ratio = 5,00,000 / 1,50,000
P/S Ratio = 3.33
Therefore the XYZ Company has a P/S ratio of 3.33, meaning that investors are willing to pay three times the company’s annual revenue for each unit of sales. Now this ratio will be compared with the peers of XYZ Company to understand whether the stock is being overvalued or undervalued.
Benefits of the Price-to-Sales Ratio for Investors
The P/S ratio serves as a valuable tool in investment analysis. It identifies undervalued stocks when compared to the revenue the company is generating. By utilising the P/S ratio, investors can make informed decisions, identify potential investment opportunities, and gain insights into a company’s valuation based on its sales performance.
Limitations of the Price-to-Sales Ratio
While the P/S ratio provides valuable insights about a company’s stock, it has certain limitations. The ratio does not consider the profitability or earnings of a company. Also, the P/S ratio may not be useful to compare companies across industries. For instance, you can’t compare a company in the IT sector with one in the FMCG sector as they drive different sales and have different capital requirements. PS ratio also does not consider other factors of a company, like debt or future growth prospects.
What Is Enterprise Value-to-Sales (EV/Sales)?
Enterprise Value-to-Sales (EV/Sales) is a financial metric that evaluates the valuation of a company as compared to its sales. It is calculated by dividing the enterprise value of the company by its total sales. While the enterprise value is the market cap of the company + debt – cash and its equivalents.
The EV/Sales ratio considers the debt of the company while calculating its worth when compared to the sales the company is generating. It helps investors assess the company’s valuation based on its revenue generation. A lower EV/Sales ratio may indicate an undervalued company, while a higher ratio may suggest an overvalued one. However, like any financial metric, it is better to use EV/Sales along with other financial metrics to understand the company.
Conclusion
The P/S ratio is one of the important ratios used by investors to understand the true worth of a stock. However, it is important to make investment decisions based on more than one ratio or metric of a company. Understand the company and consider every parameter in the financials of a company. Do a thorough industry analysis and future prospects of the company.
Check if all these align with your investment objectives and risk appetite. Talk to a reputed financial advisor before putting your hard-earned money into something. To get started with the investments, open a Demat Account now on Angel One for free. Happy Investing!
FAQs
What is a P/S ratio?
The P/S ratio or Price-to-Sales ratio is a valuation metric that compares a company’s market capitalisation to its total revenue, suggesting how much investors are willing to pay for each unit of sales the company is generating.
What does a high P/S ratio mean?
A high P/S ratio suggests that investors are paying a high price for the sales the company is generating. It can mean that the stock may be overvalued or that investors have high growth expectations for the company.
What does a low P/S ratio mean?
A low P/S ratio may indicate that the company is undervalued when compared to the revenue it is generating. It can mean either the stock can be a potential buying opportunity or that the company’s sales performance may be less compared to industry peers.
How to calculate the P/S ratio?
You can use one of the two formulas to calculate the price-to-sales ratio of a company.
- Price to Sales Ratio = Market Capitalisation / Annual Revenue Or
- Price to Sales Ratio = Latest Closing Share Price / Revenue Per Share
What is the difference between P/S ratio and P/E ratio?
Similar to the P/S ratio, the P/E ratio is also one of the key metrics used to understand the worth of a stock. The P/S ratio compares a company’s market capitalisation to its sales, while the P/E ratio compares the market capitalisation to the company’s earnings. The P/E ratio focuses on the earnings of the company.
