FOOL SCHOOL
Valuation: Price To Sales

September 21, 2005

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 lgoodosing 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 (PSR). Some studies into which valuation measures work best (e.g. What Works On Wall Street) have shown that a low PSR is one of the best indicators of value.

Definition

The price to sales ratio takes the current market capitalisation of a company and divided 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 value is £30m.

The PSR is calculated as market value divided sales for the last 12 months. 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. Its PSR would be £30m/£10m = 3.

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 results, and sales for the six month period were £8m. You calculate that sales for the last six months of the previous year were £7m, giving you a more up-to-date trailing sales figure of £15m. That would give you a PSR of 2 (£30m/£15m).

But don't forget about debt!

When looking at PSR ratios, we think it's preferable to add the debt of the company to its current market value (the combination of these two amounts is known as the company's enterprise value). The calculation is slightly more complicated but the logic 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. Many companies that have low PSRs based upon market value only (i.e. below 1), often have a lot of debt. When you look at their PSR using enterprise value, you might find they look considerably less attractive!

Going back to our example, if EPIC had debt of £30m in addition to its market capitalisation of £30m its enterprise value would be £60m. Its PSR based on enterprise value would be £60m/£15m = 4.

Comparing PSRs

The PSR is perhaps most often used to compare companies in the same industry to see if one offers better value than 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, like the P/E, next to useless as the fall in profits was only expected to be temporary.

It's also worth noting it work 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%, and typically have quite low PSRs. However, specialist retailers may have profit margins of 10% to 15% so comparing them to a supermarket could be misleading.

Other valuation measures: P/E & PEG ratio | Yield and Price to Book