The Price to Sales Ratio Has a Specific Use in Fundamental Analysis.

Price to Sales is a specific fundamental metric.

When trying to analyze the merits of buying a stock there are a number of fundamental metrics we can use when the underlying company has earnings and has been around long enough to have some historical data.

In those cases we can turn to the usual suspects — Earning per Share (EPS). Price to Earnings Ration (P/E). and Projected Earnings Growth (PEG). But those metrics do not work well on a newer company that has no earnings. This is where the Price to Sales or P/S ratio comes in to play.

The P/S ratio looks at the current stock price in relation to total sales per share. It can be calculated in two ways;

Market Cap /Revenues

Stock Price / Sales Price Per Share

Let’s use a scenario where a company had sales for the last 12 months of $5 million and has 500,000 shares outstanding. And let’s say the stock is currently trading at $20.00. The Sales per Share is equal to $10.00 ($5,000,000 / 500,000) and the Price to Sales Ratio would be calculated as $20.00 / $10.00 or 2.00.

This means that investors are willing to pay $2.00 for every $1.00 in sales. By comparing this Price to Sales number to that of other companies in the same industry you can get a better idea about how the market values it.

But as with all fundamental metrics, they are open to interpretation. If Company A has a Price to Sales Ratio of 2 and Company B has a ratio of 10, that is telling you that the market is willing to pay 5x as much for each dollar in sales with Company B.

The question then becomes Why? Is there some mitigating factor the justifies the premium paid for sales in Company B, or is it just overvalued? Is Company A an undiscovered gem whose sales ratio is cheap, or are there intrinsic problems with the company that justify the discount?

This is a good example of why you should always use a basket of fundamental metrics in conjunction with each other.

You might be asking yourself, why would anyone want to use a sales based metric instead of a earnings based one? That is a great question, since ultimately what matters in a company is how profitable it is.

The reason that Price to Sales is still used, and often the first filter for a stock screen, is precisely the fact that it uses sales instead of earnings. Sales are much harder to manipulate on an income statement than earnings. So by using the P/S ratio as a top line metric when considering a stock, you are more likely to get a viable company with which you can then drill down deeper in your analysis.

See the following topics for more on fundamental analysis;

As my series on fundamental analysis continues we will cover all those topics so you can get a well-rounded understanding of the process for picking winning stocks.

The Lund Loop is a once-weekly curated slice of what I am writing, reading, and hearing about in finance, tech, music, pop culture, humor, and the good life. But never sports or knitting. ever! Subscribe for free by clicking here .

Photo Credit: Susan Wood/E+/Getty Images