Price-To-Sales Ratio

Charles B. Carlson, CFA

Contributing Editor, Dow Theory Forecasts

Investors are always looking for ways to compare stocks. One way I’ve found to be fairly useful in comparing two stocks, especially companies in the same industry, is by looking at the companies’ price-to-sales ratio.

The price-to-sales ratio looks at a company’s market capitalization (market capitalization is the number of common shares multiplied by the stock price) divided by annual sales.

Obtaining a price-to-sales ratio is relatively painless and can be done right here at www.buyandhold.com. First, get to the BUYandHOLD home page (www.buyandhold.com). Second, click on research stocks on the left-hand side of the page. You will be taken to a page that asks for the stock symbol of a company of interest. For example purposes only, let’s plug in IBM’s stock symbol (IBM). We are now taken to a page showing International Business Machines. Click on the company name and you will be taken to a page that provides a lot of information on IBM. If you scroll down a bit, you’ll see on the right-hand side of the page a column with the heading Valuation Ratios. Under this heading you will see that IBM’s price-to-sales ratio (Price/Sales TTM) is 2.43. What this means is that Wall Street is valuing the company at 2.43 times its annual sales.

Why is price-to-sales a useful measure of value? Basically, this ratio shows how much Wall Street values every dollar of sales. Obviously, a company that can generate a lot of profit from every dollar in sales is going to receive a higher valuation per sales dollar than a company that generates very little profits from each dollar in sales.

When using price-to-sales ratios, it is important to put the numbers in some context. The best way to use the numbers is within industries. For example, let’s say you want to compare two computer software makers. If one company has a much higher price-to-sales ratio than the other, it means that Wall Street is affording a higher valuation per sales dollar for that company. This should cause you to ask yourself the following questions:

• Does Wall Street’s optimism concerning the stock with the higher price-to-sales ratio seem valid?
• Is the company with the lower price-to-sales ratio showing improving profit margins?
• Does the company with the lower price-to-sales ratio have the ability to boost its profitability per sales dollar?

Of course, a price-to-sales ratio is just one piece of data and should not be the only statistic used to evaluate a company. However, when used in conjunction with other information and ratios (price-to-earnings ratios, dividend yields), price-to-sales ratios can help fill out a fundamental examination of a stock and its appreciation prospects relative to its peers.