Price to Sales Ratio: A Simple Way to Value Companies

The price-to-sales (P/S) ratio may not have many supporters in the investment world. The ratio – defined as the current price of the stock divided by its sales per share – is often chided for focusing on sales and not taking profits and cashflow into account.

My colleague David Kuo has a nice catchphrase which can sum up the sentiment: “Sales is vanity, profit is sanity, cash is reality, and everything else is pomposity.”

But, the PS ratio does have its advantages – but only if we use it mindfully.

Mastering the art of the sale

In his book The Little Book that Builds Wealth, author and fund manager Pat Dorsey had this to say:

“The nice thing about the price-to-sales ratio is that just about all companies have sales, even when business is temporarily in the dumps—which makes P/S particularly useful for cyclical companies or companies that are having some kind of trouble that sends earnings temporarily into the red.

The trick with the P/S ratio, however, is that a dollar of sales may be worth a little or a lot, depending on how profitable the company is.

In fact, one useful way to use the price-to-sales ratio is to find high-margin companies that have hit a speed bump.

Companies that have been able to post fat margins in the past, but which have low current P/S ratios, may be discounted by the market because other investors assume the decline in profitability is permanent. If in fact the company can return to its former level of profitability, then the stock is probably quite cheap.”

With Dorsey’s words in mind, let’s take the P/S ratio out for a spin with supermarket operator Sheng Siong Group Ltd  (SGX: OV8), infocommunications firm Starhub Ltd (SGX: CC3), and rig builder Keppel Corporation Limited  (SGX: BN4).

Below, I have summarized the relevant information for comparison:

2015-07 PS Ratio Comp

Source: Companies’ earnings report; P/S ratio from Bloomberg (17 July 2015)

As you can see, Starhub traded at a higher P/S ratio last week as compared to Sheng Siong.

This could be down to the fact that a dollar of revenue for Starhub is worth more than a dollar of revenue for Sheng Siong. When we compare the net margin between the duo, Starhub is able to turn each dollar into 15.5 cents in profit while Sheng Siong only managed 6.3 cents per revenue dollar.

Meanwhile, we can also see that Keppel Corp is trading at a P/S ratio that is less than half that of Starhub’s despite the two firms having comparable net margins. The difference in this case is likely due to the uncertainty around Keppel Corp’s future revenue as a result of the oil price rout.

Foolish takeaway

The P/S ratio is another tool in the valuation toolbox for the Foolish investor. As Dorsey alluded to, while the P/S ratio is often not favored it may still become useful in specific situations like companies with temporary setbacks or cyclical companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.