A price to sales ratio (PSR) compares the total value of the outstanding shares of stock in a company to the total revenue for the last 12 months. The lower the price to sales ratio, the more value there is in each share of stock as compared to each dollar in sales. The PSR is a quick comparison that gives potential investors an idea if a company's stock is over- or undervalued.
The total value of the outstanding stock is calculated by multiplying the number of shares outstanding by the current share price on the market. The resulting value is called market capitalization. The revenue figure used in the calculation is the prior 12 months revenue, or prior four quarters, as published by the company in its financial statement or quarterly report filings. This time period is also called the trailing 12 months.
Using the price to sales ratio can be beneficial in several situations. If a company is new in its industry and has no earnings track record, but has a sales history, this ratio can provide a value indicator. If a company has lost money in the past year due to cyclical fluctuations in its industry or unusual expenses, the PSR offers a look at the results independent of expenses.
Sometimes an analyst will modify the price to sales ratio to include the company's debt in the ratio. The market capitalization figure is added to total outstanding debt to produce a number known as the enterprise value. This increased number causes the ratio to increase. This modified ratio permits the evaluator to compare two companies where one has substantial debt and the other does not. A company with high sales performance supported by high debt levels may or may not be as much of a bargain as a company with modest sales but little debt.
To utilize the price to sales ratio effectively, it is necessary to compare companies within the same industry or to understand the differences. The difference in the typical PSR between two industries can vary substantially. The apparently low ratio for a software company might not be as good as the higher ratio for a manufacturer that is actually lower in comparison to the manufacturer's competitors.
There are many other pieces of information to consider when evaluating a potential investment. A low price to sales ratio can be a good indicator that a company's stock is undervalued, but it should be reviewed in conjunction with other financial data. Making an investment decision solely on the basis of one ratio could entirely overlook other issues the company in question is facing.
