When does Price/Sales become a good metrics of company valuation? - Motilal Oswal
When does Price/Sales become a good metrics of company valuation? - Motilal Oswal

When does Price/Sales become a good metrics of company valuation?

When it comes to valuation benchmarks for stocks the most commonly used ratio is the Price / Earnings Ratio. The P/E ratio expresses how much the market is willing to pay for every rupee earned by the company. So if the EPS of the stock is Rs.12 and the stock price is Rs.240 then the P/E Ratio of the stock is 20X. The P/E ratio is normally used across industries. But then, what to do if the company is not making profits. Technically, the P/E will be negative but practically P/E of a stock cannot be negative as the price has to positive. Even if the company is making losses it has to be worth something as it has assets in its books, it is earning revenues and it has future prospects. One measure that is used in such cases is the Price to Sales ratio or the P/S ratio..

 

Price/Sales ratio = Market price of the stock / Full year sales per share
Alternatively it can also be written as
Price / Sales ratio – Market cap of the company / Net sales of the company

That brings us to the next question; what is a good price to sales ratio? Are there industry level benchmarks and country level benchmarks that can be applied? What should be the price to sales ratio for growth company and what should the P/S ratio be for stable companies? Above all, let us also understand the relevance and application of Price/Sales ratio from a practical standpoint when evaluating companies.

 

Circumstances in which price / sales ratio can be useful?

Price / Sales ratio measures what the market is willing to pay for every rupee of sales per share. Especially in case of high growth sectors, the P/S ratio can be very useful as a valuation measure. A combination of high growth in the sector and low P/S ratio can be a good starting point for identifying a future star in the stock market.

The P/S ratio can be very useful in case of cyclical sectors. For example, steel and aluminium go through long up phases and prolonged down phases. Their profitability ranges from high profits to high losses. The P/E ratio can be quite deceptive in such cases and the P/S ratio is a more reliable indicator.

P/S ratio also works very well in case of companies where the entire sector is undergoing a major disruption. Telecom is one such example. There is big growth in data but that will take some time to translate into sales. However, the way it is being disrupted the impact on sales is going to be substantial and rapid. P/S ratio will make a lot more sense in such cases.

P/S ratio is a good measure when the company or sector is going through temporary down cycle. The profits may have started falling but you are not sure if you can read too much into the profits story. In such cases, if the growth in sales continues at the same pace then it gives you confidence that profit growth will also eventually come back. In such cases, P/S is a good backup for the P/E ratio.

The advantage of the P/S ratio is that at a time when profitability parameters cannot be applied, the efficiency parameters can still be applied. Even when the company in question is not making profits, the P/S ration and Sales/assets ratio can still be calculated and that combines the rate at which the price discounts the sales and the operating efficiency of the company.

The sales figure is less susceptible to manipulation as compared to the earnings data. In case of earnings, there is scope for the company to misrepresent on items like depreciation, interest and taxes. Sales are easier to cross-check as the data on sales is also available at an industry level and hence is less prone to manipulation.

P/S ratio can be very useful as an added balance check on the valuation methodology. For example, the P/E Ratio is a mix of performance and perception. Different analysts have different perceptions of earnings quality of companies. In the case of the P/S ratio there is more of reality and less of perception involved. Hence, when combined with the P/E ratio, the P/S Ratio gives a more realistic picture.

The price to sales ratio (P/S) has emerged as an important method of fine tuning your stock analysis and valuation methodology. While its applicability as a standalone technique may be limited, it can add value when used as an adjunct to other valuation methodologies. In specific cases like loss making companies, cyclical companies and disruptive sectors; the P/S Ratio does add a lot of analytical value.
 

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