Understanding price to sales ratio

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One of the simplest ratios for valuing companies is the price to sales ratio. This relates the market value of the company to its annual sales. The exhaustive testing of the idea that this simple calculation could be used as the basis for assessing shares was done by John O'Shaughnessy in his book What Works on Wall Street, first published in 1996.

O'Shaughnessy tested the idea on a large number of companies using data spanning some 40 years starting from the immediate post-war period. His studies discovered that the price to sales ratio (PSR) was one of the best indicators of future share price performance.

Get more on how to implement it into your investment decisions in: Using the PSR.

Companies that had a PSR of less than one (that is, with a market capitalisation less than their annual sales) generally performed well, while those with a PSR of greater than one generally underperformed.

This modest ratio may come as something of a surprise to sometime analysts of internet stocks, who tended to treat a revenue multiple (another name for the PSR) as analogous to the PE ratio, with stocks standing on 10 times revenue being judged cheap, if they were growing quickly enough.

Not surprisingly this absurd idea, a travesty of O'Shaughnessy's formula, led to a widespread overvaluation and subsequent collapse in the market for internet companies in 2000.

Even in normal circumstances there can be problems calculating precisely which measure of revenue to use. Where calculations differ usually revolves around whether or not to use the sales numbers for the last reported year, or the last 12 months.

Using the last 12 months' figures is common practice for US companies, because they report quarterly. In this case, the figure to take (assuming a forecast is not used) is the cumulative sales figures for the preceding four reported quarters.

If, for example, a company has recently announced third quarter sales, the last twelve months' sales figures would be the sales for the nine months of the current year added to the fourth quarter of the previous one.

In the same way, for companies reporting twice yearly, if a half-year has been reported, sales in the first half of the current year would be added to those of the second half of the previous year. In all other cases the last reported full year sales figure is the correct one to use.

There are other conceptual difficulties over the PSR. All companies are different from each other and have different levels of profitability. Revenue for food retail companies or international trading companies is often many times their market value, because the profit margins on food retailing or international trading is often very low. This means it is difficult to assume that the PSR is a reliable yardstick in all cases.

O'Shaughnessy didn't seek to explain in detail why the PSR should work as a valuation yardstick. He simply noted that the data indicated that it had worked consistently in the past.

Another problem with the ratio is that revenue is defined in different ways for different companies. Analysts who look at life insurance companies and banks have developed conventions for calculating revenue that differ from the normal accounting for revenue adopted by industrial companies.

The PSR is a hard concept to use for any company that uses a convention for calculating revenue that differs from the normal mainstream.

As well as financial companies, the PSR also has limited relevance for companies that can be described as 'asset situations'. Here, value rests on relating the value of assets to the (usually substantially lower) market value of the company.

Peter says

Taking the PSR in isolation risks oversimplifying matters. But the ratio can be used as one of a range of measures to value companies, along with return on equity, the PE ratio, price to cash flow ratios, discounted cash flow and other calculations.

I have personally used the PSR on a number of occasions, typically to help find the cheapest stock out of a range of companies selected by other means. Because of the ease with which it can be calculated it is one of the most useful financial ratios around, even if it can't be used in all cases.