There are numerous ways on how to measure the value of equities. One of them is the price-to-sales ratio, sometimes written as Price/Sales or P/S. This is one of the simplest approaches in scaling the value of stocks. You must first get the market capitalization of the entity (number of shares times the price of the share). Then, divide the result by the entity’s overall revenue within 12 months. The lesser ratio you get, the better investment it is.
This approach can seem to be enough, but investors should still be aware of the possible downsides and weaknesses of this ratio.
How to use the Price/Sale Approach?
You can use this ratio to evaluate the value of the profit of a company listed on the Philippine Stock Exchange. With a strong growth within the 12-month period combined with a low price-to-sales ratio, it becomes an efficient way to choose an investment.
The method can also be used in assessing the value of growth stocks that have previously experience a short-time decline. For example, in the semiconductor industry, there will be companies in this industry which will not get any earnings for a year. When this happens to companies, you have to use the price-to-sales ratio and not the price-earnings ratio (P/E Ratio or PE) to evaluate every dollar in the sales of the company and not the earnings. You use the ratio either for assessing the regain of the company or checking if its growth is not becoming overrated. This is much better to use it in companies that have suffered year-long losses. Because those companies do not have any yields, their Price-to-Earnings ratio cannot be measured.
Weaknesses of a P/S Ratio
There are two ways of measuring a company’s growth. Usually, investors are looking at the sales revenue of a company. This is the most basic when it comes to evaluating a company. However, this indicator is not always reliable because of complicated accounting rules.
The second one is the earnings. Just like the first one, this indicator also has its weakness. That is because of the tendency of a turnover or a regain. Combine that with the discrepancy of differences of the condition of companies. No company’ sales could be treated the same. Therefore, the earnings indicator can be very hard to use.
What an investor must do is to carefully analyze the sales, profit margins, the trends, and sector-specific margin idiosyncrasies.
Always Consider the Debt of the Company
When comparing companies with similar P/S ratio, you can consider their debts. Even if two or more companies have the same price-to-sales ratio, the company that has no debt is better than the rest.
The companies that have an outstanding debt have a high possibility that they will issue new shares to the investing public. This will cause the market capitalization to expand and increase the P/S ratio. On the other hand, companies with debt on the edge of bankruptcy can still have a lower price-to-sales ratio if they don’t experience any decline while their capitalization and price share collapses.
With this dilemma, how can investors choose the better one?
Investors should use the enterprise value/sales and not the market capitalization/sales.
First, you must add the long-term debt of the company to its market capitalization. Then, you can subtract any cash. The result will be the EV or enterprise value of the company.
Enterprise value is the total price for the company, plus the outstanding debt and money left, which will counterbalance the price. It will indicate how much will be left in the debt if an investor buys the company. It also helps the investors to compare two kinds of companies: the one that depends on debt to improve sales; and the one without debts but with lesser sales.
There are many other methods of company evaluation, and the use of sales as an indicator is just a basic criteria. You should still look at the fundamentals before buying equities. Sure, the lower price-to-sales ratio can spot the hidden potentials of a company BUT you should couple it with other criteria such as low debt levels, growth prospects, and high-profit margins. Without enough consideration of the other indicators, you could end up in the price-to-sales ratio pitfall.
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