Finding Value in the Price-to-Sales Ratio

The price-to-sales ratio is a common tool that many investors use to value stocks. This method has been around for some time and it has proven that it does have some merit when valuing stock purchases. Here are the basics of the price-to-sales ratio and how it works.

Price-to-Sales Ratio

The price-to-sales ratio is an indicator that many people look at before they purchase a stock. It is actually one of the easier calculations that you can make whenever evaluating stock. In order to calculate this ratio, you first need to determine the market capitalization of the company. This can be done by taking the number of shares that are available in the market and multiplying that by the price per share. Once you have a market capitalization, you can simply divide that number by the total sales for the past year. The number that you are left with will represent the price-to-sales ratio.

What to Look For

Just because you can calculate the price-to-sales ratio of any company does not mean that you know how to use this information. Once you have this ratio, you should compare it to some other companies in the industry. If you have a value that is less than 1.0 and other signs of strength in the company over the past year, this tells you that the stock could potentially be a good buy.

Why It's Valuable

Many investors believe that the price-to-sales ratio is more valuable than the price-earnings ratio. Just because a company does not necessarily have much in the way of earnings over the previous year does not mean that the company is in bad shape. Instead of looking at the earnings, the sales can sometimes give you a better picture of what is in store for the company. For example, in many of the technology sectors, some companies will not post any earnings for an entire year. This is due to the nature of the industry and not specifically the performance of the company itself.

With growth stocks, they can sometimes be better to look at the price in relation to the sales that the company has generated. If the company has significant sales compared to the price, you could have a bargain on your hands.

Debt

When you are utilizing this ratio, you will also want to take a look at the debt of the company. Ideally, you would like to invest in companies that have a low price-to-sales ratio and a low amount of debt. Companies that have high amounts of debt can also have the same price-to-sales ratio and not present as attractive of an investment opportunity.

Drawbacks

Just like every valuation method, there are some drawbacks associated with this one. It is not perfect because it does not take many different factors into consideration. You cannot just look at the sales and the market capitalization of a company in order to determine if it is valued correctly. You have to look at the entire picture before you can make any assumptions.

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