Although not as common as the P/E Ratio, the P/S Ratio is also a very useful indicator when seeking for above average returns. Billionaire investment guru and bestselling author Kenneth Fisher believes that the Price to Sales Ratio reveals a lot more than the Price to Earnings Ratio.
What is the Price to Sales Ratio?
The P/S Ratio is simply the price of the share divided by the total sales (revenue) per share of the stock in the last 12 months. For example, if the stock costs $40 and it earned $10 in revenue per share in the past year, then the P/S ratio would be $40/$10 = 4.
Similar to the P/E ratio, it basically indicates how much you’re paying per dollar of sales. If the P/S ratio is 4, that means that you are paying $4 for every dollar of revenue the firm is making.
Why should you use the P/S Ratio?
How is the P/S any different from the P/E ratio and why do some investment gurus such as Ken Fisher (Other than he kind of pioneered the academic study of the P/S ratio) choose to use the P/S ratio?
Earnings can fluctuate a lot more than sales. If a company decides to replace a lot of old equipment in a particular year and its earnings decrease. It’s P/E Ratio will fall but its P/S Ratio will remain the same if their sales are maintained. This indicates that the P/S ratio is a better indicator of the company’s growth as the sales number tends to be more consistent.
It is also better for taking advantage of investor’s psychological tendencies. A lot of companies that get hyped by Wall Street always start off with a strong period of early growth until high expectations drive the stock way above any reasonable value. Once the company hits a bump, and their earnings drop or don’t meet the high expectations of investors, the stock price may fall drastically.
However, this does not mean that the company is not growing. Often the sales of the company remain strong and one can use this opportunity to find great companies by looking at the P/S ratios. Stocks with P/S of less than 1.5 tend to be a good deal, but Ken Fisher looks for “Super Stocks” with P/S ratios of less than 0.75. Of course, this is used in conjunction with other quantitative and qualitative considerations but it does nevertheless serve as a good screening ratio.
Things to look out for:
Firms that grow slowly, such as those that are in the manufacturing or industrial businesses tend to have an overall lower P/S ratio which means you should adjust your criteria accordingly when looking at these kinds of firms. Also, as I mentioned earlier, terrible companies can also have low P/S Ratios because the investors have already factored their problems into the price so it is important to use other indicators and your own judgment before making a decision to buy a stock.
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