FOOL SCHOOL
Valuation: Price To Sales

January 11, 2002

Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Companies that may be temporarily losing money, have earnings depressed due to short-term circumstances (like product development or higher taxes) or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price to sales ratio, often simply abbreviated to PSR.

The price to sales ratio takes the current market capitalisation of a company and divides it by the sales it made in the last 12 months. The market capitalisation is the current market value of a company, arrived at by multiplying the current share price by the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company in this series, Epic!, has 10m shares outstanding priced at 300p per share, then its market capitalisation is £30m.

The PSR is calculated as:

Market Capitalisation 
---------------------- 
    Trailing Sales 

For a quick fix on trailing sales, you can take the number as reported in the company's last published annual report. Say Epic! produced sales last year of £10 million. The PSR would be:

   £30m 
 --------  =  3 
   £10m 

The average UK company reports results every six months. Some companies, especially those whose shares are traded on US markets, report results every three months. In order to get the most up to date trailing sales figure, investors can calculate the number based on the latest published results. For example, say Epic! has just announced its first half-year results, and sales for the six month period were £7m. You calculate that sales for the last six months of the previous year were £6m, giving you a more up-to-date trailing sales figure of £13m. That would give you a PSR of 2.3.

When looking at PSR ratios some investors add the current long-term debt of the company to its current market capitalisation. This figure is known as the enterprise value. The logic here is that you are looking at the total capital that is being invested to support the company, and hence produce its current level of sales. This helps you make a better comparison between PSRs of two companies if one has taken out enormous debt that it has used to boost sales and the other has lower sales but has not added any debt.

So if Epic! had debt of £10m in addition to its market capitalisation of £30m its enterprise value would be £40m. Its PSR based on enterprise value would be 3.1.

How To Use The PSR

In a word - carefully. Some studies into which valuation measures work best (e.g. What Works On Wall Street) have shown that a low PSR is often a good indicator to use. But, as with any valuation ratio, it is often dangerous to be use it in isolation.

The PSR is often used to compare companies in the same industry to see if one offers value compared to its competitors. For example, a company may fall upon hard times for a couple of years and see its profits wiped out completely. This would make any earnings based valuations next to useless, if the fall in profits was only expected to be temporary.

It works best with industries that tend to have similar profit margins amongst all the main players. For example, UK supermarkets have recently enjoyed margins of around 5%. Other retailers tend to a little higher, perhaps between 5% and 10%. These industries will have low PSR ratios. Other companies with high profit margins (e.g. large software companies) will tend to have high PSRs. In industries with a few dominant players and a few tiddles the typical profit margins will vary significantly. Here the PSR is less useful.

New companies are often valued on PSR ratios as well. However, you need to be a lot more careful when applying this measure in this instance. The idea of the PSR is to find companies who will return to profits relatively quickly. A new company may not reach profitability for many years.

Other valuation articles:
The PE ratio
The PEG ratio
Dividend Yield
Return on Equity
Return on Equity and Goodwill
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow