Price-to-Sales (P/S) Ratio: Measuring a Company's Revenue

Ravi was sitting in his favourite coffee shop, scrolling through financial news on his phone. While reading the financial news, he stumbled upon the "Price-to-Sales Ratio" and decided to understand it as part of his investing toolkit. This ratio helps investors evaluate a company's revenue effectively.

What is the Price-to-Sales (P/S) Ratio?

The Price-to-Sales (P/S) ratio shows how much investors are willing to pay for each rupee of a company’s revenue. It compares the stock price to total revenue, giving insight into the market’s valuation of a company’s sales. Mathematically, it's calculated as:

P/S Ratio = Market Value per Share / Sales per Share
Often called the "sales multiple" or "revenue multiple," this ratio helps investors gauge market expectations of future growth, with a high ratio suggesting optimism and a low ratio possibly indicating undervaluation.

Understanding the P/S Ratio

This ratio is especially useful when comparing similar companies within an industry. For example, high-growth tech firms may have higher P/S ratios compared to retailers with smaller margins. Industry norms are essential here—what’s high in one sector might be average in another.
Example
Suppose Inkit Co. has ₹455 million in sales over the last year, 100 million outstanding shares, and a stock price of ₹10 per share:

• Sales per Share (TTM) = ₹455 million / 100 million = ₹4.55
• P/S Ratio = ₹10 / ₹4.55 ≈ 2.2
  If peers trade at an average P/S of 1.5, Inkit's higher P/S ratio implies investors expect higher growth relative to competitors.

Utility of the P/S Ratio

The P/S ratio can reveal if a company is valued fairly by the market based on its sales. This metric is valuable for analysing growth-focused companies, such as startups, as it focuses on revenue and disregards profitability, which may be low or negative for young companies. By focusing on sales rather than earnings, the P/S ratio is ideal for spotting potential in high-growth industries.

Limitations of the P/S Ratio

While helpful, the P/S ratio has limitations:

• Profitability Insight: It overlooks profitability, meaning two companies with identical P/S ratios might differ significantly in their ability to turn sales into profit.
• Debt Exclusion: It doesn’t consider debt. If two companies have the same P/S but different debt levels, the company with more debt has a higher risk, unaccounted for by the P/S ratio.
• Industry Differences: Cross-industry comparisons can be misleading due to differences in profit margins.

For a more rounded picture, the Enterprise Value-to-Sales (EV/Sales) ratio accounts for debt and cash, offering a more comprehensive view.

Using the P/S Ratio for Investment

Ravi can use the P/S ratio to spot undervalued opportunities. However, he should combine it with other financial metrics, like the Price-to-Earnings (P/E) ratio and Debt-to-Equity ratio, to ensure a balanced view of the company’s financial health and avoid risks.

Conclusion

The P/S ratio offers valuable insight into a company's revenue potential. As you complete the valuation ratios module, you’re ready to explore how industry and sector analysis can further enhance your understanding of company performance.