Price-to-Sales Ratio (P/S Ratio) is a valuation metric that compares the share price to the sales (revenue) per share. Unlike the Price-to-Earnings Ratio, the figure is difficult for accountants to tamper with.
Price-to-Sales (P/S) Ratio
Price-to-Sales Ratio (P/S Ratio) is a valuation metric that compares the share price to the sales (revenue) per share. The P/S Ratio is popular because, unlike the Price-to-Earnings Ratio, it doesn't depend on the company showing a profit and the figure is difficult for accountants to tamper with.
'Price-to-Sales Ratio' Formula
The Price/Sales Ratio is calculated by dividing the price per share by the revenue per share.
There are three versions of Price-to-Sales Ratio that analysts often use.
- Trailing P/S Ratio: the average number of common shares outstanding over the last 12 months period divided by the revenues from the same period
- Quarterly P/S Ratio: the average number of common shares outstanding over the last quarter divided by the revenues from the same period
- Projected P/S Ratio: uses the mean estimated net sales for the current or next year, as provided by analysts from various financial publications
P/S Ratio Interpretation
As with all valuation techniques, sales-based metrics should not be examined in isolation. A low Price-to-Sales Ratio could indicate unrecognized value provided other criteria such as low debt levels and growth prospects are in place. However, Price-to-Sales could also be a "value trap".
One of the most potent investment strategies is to screen for companies with a low P/S Ratio coupled with high relative strength in the previous year.
A low Price-to-Sales Ratio can also be used to screen for growth stocks that have suffered a temporary setback. Sometimes a minor tweak to operating efficiency can turn a money-losing business with low P/S Ratio into a profitable company.
In highly cyclical industries such as semiconductors, there are years when many IC companies do not produce any earnings. In such a situation, investors can screen stocks based on Price-to-Sales instead of P/E Ratio. Price-to-Sales can be used for spotting recovery situations.
A company with no debt and a low Price-to-Sales metric is more attractive than a company with high debt and the same Price-to-Sales Ratio. At some point, the debt will need to be paid off, so there is always the possibility that the company will issue additional equity. These new shares expand market capitalization and drive up the Price-to-Sales Ratio.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Price-to-Sales Ratio is such a factor, having been correlated with past stock returns for many years and also expected to be correlated with future returns.
The P/S Ratio exhibits the good quantitative characteristics when analyzed using both short and long investment horizon. The investment horizon, also referred to as "rebalance period", is the period of time stocks are held prior to refreshing the portfolio holdings. The Price-to-Sales Ratio achieves good results with weekly, monthly, quarterly and yearly rebalance, making it a valuable fundamental factor.
The Quantitative Analyst assesses individual stock factors by:
- separating the stocks into quintiles (or deciles) based on the value of the factor
- calculating the performance of each quintile based on rebalance period and total back-test period
- analyzing the spread of performance between Quintile 1 to Quintile 5
Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, the stocks from the Russell3000 Index were sorted into quintiles based on P/S Ratio, then evaluated over the 10 year back-test period 2005-2014 with a 3 month rebalance period.
Using the above process, the stocks from the Russell3000 Index were evaluated over the 10 year backtest period 2005-2014 with a 3 month rebalance period.
From the above column chart, it can be seen that the quintiles exhibit monotonic behavior which is a good thing for single factor testing. In Quantitative Analysis, single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value. There are many other considerations involved in the construction of a portfolio that will change the performance numbers.