In this article, we’re going to explore the Price to Sales ratio (aka P/s Ratio), and learn how to calculate Price to Sales Ratio, too.
What is the Price to Sales Ratio?
The Price to Sales Ratio (aka P/s ratio) is a valuation ratio (or fraction) of the current market price of a stock (the share price), relative to its revenue per share (or sales per share).
The Price to Sales Ratio shows you how much you pay for every $1 of revenue that the firm earns.
RELATED: How to Calculate Stock Price
Interpreting the P/s Ratio
The interpretation of the P/s ratio is actually fairly similar to the interpretation of the Price to Earnings Ratio (or PE ratio).
We can see the P/s ratio as a proxy for the firm’s growth opportunities.
But if you do see it this way, you want to see it with quite a lot of caution.
That’s because the Price to Sales ratio ultimately relies on Sales instead of Profit. This makes it a lot less robust compared to the P/e ratio.
And that’s ultimately because firms can have considerably high sales, but still incur significant losses.
As the old investor saying goes, “revenue is vanity, profit is sanity, and cash is reality”.
So the Price to Sales Ratio focuses on a vanity metric in a sense.
Because you can have the highest sales in the world…
But if your operations aren’t good; if your costs aren’t managed well; then you almost certainly will end up making significant losses.
And that might well translate into negative cash flow as well. That in turn could ultimately just push you down into insolvency or bankruptcy as the trickle down effect.
Applicability of the P/s Ratio
Having said that…
The Price to Sales ratio can be applied to more firms than the Price to Earnings ratio (PE Ratio).
And that’s ultimately because there are more firms that have positive revenue, compared to the number of firms that have positive earnings (i.e., the number of firms that earn profits).
In other words, there are many more unprofitable companies than there are profitable ones.
Now, of course, as any entrepreneur will tell you, earning revenue is not the easiest thing in the world.
But earning a profit is certainly more challenging than earning sales revenue.
And so there inevitably will be more firms that have some sort of revenue but don’t quite make it to the point where they make a profit.
If you think about Amazon, they suffered significant losses for several years.
It took them a while before they earn their first profit.
Alright. Hopefully, you’ve kind of got a feel for what the Price to Sales Ratio is.
Let’s now explore how to calculate Price to Sales Ratio.
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How to calculate Price to Sales Ratio
The Price to Sales (P/s) ratio can be calculated as…
Where reflects the Price of 1 share, and refers to the Revenue Per Share, estimated as…
Here reflects the total number of shares outstanding. And of course, because Revenue is an Accounting term, and an accounting convention, there’s a whole host of other terms that are used to describe exactly the same thing.
Revenue is also called…
- Top Line
All you need to know is that all of these terms mean exactly the same thing.
We’re talking about the total revenue of the firm.
Firm Level vs. Stock Level
Now, similar to the Price to Earnings Ratio, the Price to Sales ratio can also be expressed at the firm level instead of the stock level.
To do that, you would calculate the P/s by taking the Market Capitalization (aka Market Cap) and dividing it by the Total Revenue. In other words…
Now, to see why this is true, we can start with the generalised equation of the Price to Sales ratio, which we know is simply this…
And we know that the is the total revenue divided by the number of shares.
We can therefore rewrite this equation like so…
And now, because we’ve got a fraction in the denominator, we can rewrite the equation like so…
This is equivalent to writing it as…
Now, Price multiplied by the Number of Shares is nothing but the Market Capitalization (aka Market Cap).
We can therefore express the Price to Sales Ratio as…
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P/s Ratio Example (Snap Talk Inc)
Consider Snap Talk Inc., which reported sales of $108 million. The firm has 30 million shares outstanding, and its current stock price is $42.90.
What is the firm’s Price to Sales Ratio?
It might be a good idea to pause for a sec and see if you can solve this by yourself using the equations from above.
We’re going to assume that you did that.
Let’s go ahead now and learn how to calculate price to sales ratio together.
We know that the price to sales ratio is estimated as…
We know that the share price in Snap Talk Inc’s case is $42.90
All we need to do is work out the , which we’ll estimate as…
That gives us a sales revenue per share of $3.60.
And now it’s just a simple case of dividing the stock price by the so that…
Solve for that, and you’ll see that the Price to Sales Ratio is approximately equal to 11.92
Interpreting the result
This means that investors are paying $11.92 for every $1 of revenue Snap Talk Inc earns.
So they’re paying a multiple of 11.92.
RELATED: Multiples for Valuation
Now, from a practical standpoint, a Price to Sales Ratio / Multiple of 11.92 would be extremely high.
And you don’t tend to see this in the data all that much.
Although of course, there are cases where you have firms with this high a P/s multiple, and indeed even higher.
But generally speaking, if you find a firm that has such a high price sales multiple, it might be the case that the firm is overvalued.
But that certainly depends on which industry it belongs to and a whole host of other factors.
Price to Sales Industry Variations
If you were to look at the data across the board, you’ll likely find that the Price to Sales ratios tend to be less than or equal to three.
By no means is this some sort of benchmark or a rule of thumb or anything of the sort.
It’s always important to remember that there are in fact tens of thousands of publicly listed companies, perhaps even hundreds of thousands (globally).
And if you include all the companies out there – private and public firms – then you’re talking about several million, perhaps tens or hundreds of millions of companies on a global scale.
So to come up with a sort of generalised rule based on a multiple of this sort is quite ambitious. And perhaps naïve.
Having said that, there are some sort of trends that do become apparent.
For instance, the Price to Sales ratio tends to be significantly higher for tech companies.
And that’s just the nature of tech firms.
Most multiples tend to be exorbitantly high for tech companies, but not so much for say, traditional manufacturing firms.
Generally speaking, you’ll have quite a low Price to Sales Multiple for manufacturing companies and quite a high one for tech companies.
In summary, we learned that the Price to Sales Ratio shows you how much you pay for every dollar of sales the firm generates.
We calculated by taking the price and dividing it by the revenue per share, or .
We said that the P/s Ratio multiple can be applied to more firms compared to the Price to Earnings (P/e) ratio.
That’s predominantly because it relies on sales instead of profit. And of course, there are more firms that earn sales compared to the number of firms that earn profit.
Related Course: Stock Valuation (using Multiples)
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