What is the Price-to-Sales Ratio?
The Price-to-Sales Ratio (P/S) measures the value of a company in relation to the total amount of annual sales it has recently generated. Often referred to as the “sales multiple”, the P/S ratio is a valuation multiple based on the market value that investors place on the revenue belonging to a company.
- What is the formula used to calculate the price-to-sales (P/S) ratio?
- For which company growth stage is the price-to-sales ratio typically used?
- What range is considered an “attractive” sales multiple?
- What are some limitations of the P/S ratio?
In This Article
Price-to-Sales Ratio Definition
The price-to-sales ratio indicates how much investors are currently willing to pay for a dollar of sales generated by a company.
The price-to-sales ratio tells us how much value the market places on the sales of a specific company, which is determined by the quality of revenue (i.e. customer type, recurring vs. one-time), as well as expected performance.
Higher P/S ratios can often serve as an indication that the market is currently willing to pay a premium for each dollar of sales.
Price-to-Sales Ratio Formula
The price-to-sales ratio (P/S) can be calculated by dividing the latest closing share price by its sales per share as of the latest reporting period — which is ordinarily the latest fiscal year, or an annualized figure (i.e. trailing twelve months with a stub-period adjustment).
Another method to calculate the price-to-sales ratio involves dividing the market capitalization (i.e. total equity value) by the total sales of the company.
Interpreting the Price-to-Sales Ratio
A low price-to-sales ratio relative to industry peers could mean that the shares of the company are currently undervalued.
The standard acceptable range of the price-to-sales ratio varies across industries. Hence, benchmarking the ratio must be done among similar, comparable companies.
Alternatively, a ratio in excess of its peer group could indicate the target company is overvalued.
Price-to-Sales Ratio Limitations
The major downside of the price-to-sales ratio that tends to reduce its reliability is that the P/S ratio does NOT factor in the profitability of companies.
While the main advantage of using the P/S ratio is that it can be used to value companies that are yet to be profitable at the operating income (EBIT), EBITDA, or net income line, this fact is also the main drawback.
Since the price-to-sales ratio neglects the current or future earnings of companies, the metric can be misleading for unprofitable companies.
Additionally, the price-to-sales ratio fails to account for the leverage of the company being evaluated – which is why many prefer to use the EV/Revenue multiple.
Excel File Download
Now, we’re ready to move on to an example calculation of the price-to-sales ratio. To download the Excel file, just fill out the linked form below.
Price-to-Sales Ratio Calculation Example
In our hypothetical scenario, in which we’ll calculate the price-to-sales ratio, we’ll compare three different companies.
For all three companies – Company A, B, and C – we’ll use the following assumptions:
- Latest Closing Share Price: $20.00
- Diluted Shares Outstanding: 100mm
With those two assumptions, we can calculate the market capitalization for each company.
- Market Capitalization = $20.00 Share Price × 100mm Diluted Shares Outstanding
- Market Capitalization = $2bn
Next, we’ll list the assumptions related to each company’s sales and net income in the last twelve months (LTM).
- Company A: Sales of $1.5bn and Net Income of $250mm
- Company B: Sales of $1.3bn and Net Income of $50mm
- Company C: Sales of $1.1bn and Net Income of -$150mm
If we compute the P/E ratio for our example peer group, we’d get:
- Company A: $2bn ÷ 250mm = 8.0x
- Company B: $2bn ÷ 50mm = 40.0x
- Company C: $2bn ÷ -150mm = NM
From the list above, the P/E ratios provide minimal insight into the valuation of the three companies.
The P/E ratio tends to be most useful for mature, stable companies. But here, Company B and C each have P/E ratios that are not meaningful due to being barely profitable or not profitable.
If we calculate the price-to-sales ratios for these same three companies, we can obtain a better understanding of how the market is valuing each in comparison to one another.
- Company A: $2bn ÷ 1.5bn = 1.3x
- Company B: $2bn ÷ 1.3bn = 1.5x
- Company C: $2bn ÷ 1.1bn = 1.8x
In closing, we can see how the price-to-sales ratios are typically in a more compact range, which helps make comparisons more practical, unlike the P/E ratios that can deviate far from one another.
From the example we just completed, it’s clear why the price-to-sales ratio is frequently used (or oftentimes is the only option) for companies struggling to get past the break-even point or are unprofitable.