The price-to-sales ratio may help you to spot potentially undervalued stocks and also excess risk in your portfolio. But remember that the p/s ratio is just one tool to spot value or lack thereof.
When stock prices rise, it becomes increasingly difficult to find stocks that offer good value. One tool you can use to help spot value and risk is the price-to-sales ratio.
The p/s ratio, calculated as a stock’s price divided by its sales per share, gets much less attention than it deserves. After all, you may look on sales as the raw material of profit but they are also much more stable than profits.
Then too, this ratio may be a big help with companies that have yet to make serious profits—small-caps and concept stocks come to mind.
The p/s ratio deserves more credibility than, say, p/e (price-earnings) ratios or dividend yields. A company’s management can depress or bloat earnings, and it may raise or lower dividends, but fiddling with sales figures verges on fraud.
If a low-profit, or no-profit, company has high sales per share in relation to its share price, or a low p/s ratio, it may have more potential than you’d guess from its earnings report. It may be able to restore or boost profits simply by cutting costs.
The p/s ratio may also weed out a list of high p/e stocks. A company selling at 25 times its earnings may be worth a look. A company selling at 25 times its sales is almost always overpriced.
Three drawbacks of the p/s ratio
While useful, the p/s ratio also has its drawbacks. Here are three:
■ P/S ratios ignore leverage. A company’s capital comes from a variety of sources. A $10 stock that has $200 in sales per share has a low p/s ratio of 0.05. But it may never turn those sales into per-share profits if it has a high debt-load because interest costs will eat up the operating income.
■ P/S ratios may vary by industry. Service companies and those that operate mines and oilfields can be attractive despite a high p/s ratio. That’s because they can typically turn a lot of their sales dollars into profits.
■ Companies on the verge of bankruptcy almost always have low p/s ratios. That’s because their sales may merely slump while their share prices plunge.
The standard rule of thumb is that a stock with a p/s ratio below 0.75 is considered an undervalued buy. Also, you should avoid purchasing stocks when their p/s ratio is above 3.0. As always, remember that the p/s ratio is just one tool to spot value or lack thereof.
The p/s ratio may also help you spot excess risk in your portfolio. If all your stocks have a p/s ratio above 2.0 (i.e. if all your stocks trade at more than twice their sales per share), you leave yourself vulnerable to substantial losses at any time, especially in a market setback.
You should never buy a stock purely because of a low p/s ratio. After all, it’s much easier for a company to make a sale if it’s willing to lose money on that sale. Businesses, however, can’t go on losing money forever.
This is an edited version of an article that was originally published for subscribers in the July 27, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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