Is Price-to-Sales Ratio a Superior Valuation Metric?

by Editor, Global Beta Advisors

Systematic value investors face a lot of options when deciding which value metric they should utilize when constructing their portfolios. Unfortunately, common valuation metrics such as price-to-earnings (or the PE ratio) are prone to inaccuracies due to arbitrary increases in the life span of assets or changes in depreciation calculation methods that easily manipulate earnings or profits (Source: Investopedia).

Calculating Market Value

Enter price-to-sales. Developed by stock market guru Kenneth L. Fisher, the price-to-sales ratio, or PSR, uses sales as the primary parameter when evaluating companies. Sales are typically more difficult to manipulate than earnings or profits. They also tend to be more stable, with the sales of strong companies remaining more or less constant over a period of time. This means that PSR may be a superior metric when seeking to identify undervalued or overvalued stocks (Source: Forbes).

Calculating PSR

There are two simple ways to calculate the price-to-sales ratio. In the first, the market price of the stock is divided by the sales per share. In the second, the market capitalization of the company is divided by annual sales. The result is the number of years in which the company’s sales equal its market capitalization (Source: MarketBeat).

What is a Good PSR?

Generally, the lower the PSR, the better value the stock in question, with PSRs between 1 and 2 considered good and PSRs of less than 1 generally considered excellent. However, optimal PSRs can vary significantly between industries.

For non-cyclical and technology stocks, a PSR of less than 0.75 is considered highly desirable, though a PSR of 0.75-1.5 may also indicate a good pick. Non-cyclical and technology stocks with PSRs over 3 are generally considered risky.

When valuing cyclical stocks, a PSR of less than 0.4 is considered highly desirable, though a PSR of 0.4-0.8 may still be considered investment worthy. It’s generally advised to avoid cyclical stocks with PSR higher than 0.8 (Source: Economic Times).

PSR Caveats

As with any valuation metric, there are limitations to the application of the price-to-sales ratio. Because PSR varies widely across industries, it is difficult to compare companies across a range of sectors. It also does not distinguish between a leveraged and unleveraged company. An organization might have a low PSR but be on the verge of bankruptcy due to high interest costs.

PSR also does not give investors an idea of the company’s profitability and cost structure. For this reason, we generally advise investors to utilize price-to-sales valuation in conjunction with other factors such as the debt-equity ratio, earnings growth, and free cash flow.

Vince Lowry, CEO of Global Beta Advisors, speaks to these factors in this free on-demand webinar, Harnessing The Power Of Price-To-Sales, which you can watch here.