Pros and Cons of Using Price-To-Sales (P/S) Ratio
In the world of trying to understand the intrinsic value of a company there are a variety of approaches. One method is using the price to sales ratio (P/S) which is relatively simple.
P/S Ratio = Market Cap/Trailing Twelve Months Revenue (TTM)
It equates to how much investors are willing to value the company for every dollar in sales. If you can own a company for a lower P/S ratio that is preferable (but it is a bit more nuanced that just lower always means better). Let’s get right into my thoughts on the valuation multiple and how I tend to use it.
Smooths out Profitability for Cyclicals
The nature of cyclical businesses is that they go through boom and bust periods for profitability. What I mean by that is one year the company is making $3 billion in profits and the next they make only $1 billion due to market dynamics a bit out of their control.
A simple P/S ratio can give you an idea if you are getting in at a relatively good time looking at a historical range for the industry.
One example would be the steel industry (or any commodity business). In a business that is tied to economical cycles as well as at the mercy of fluctuating commodity pricing, steel companies have this boom and bust nature of profitability.
Looking at a company like Nucor (NUE), we can look at the the historical range of P/S over the years as a public company (using a free website like macrotrends.net).
You can see when the economy was in the dumps back in 2009 the P/S ratio dipped to a lower range (the same thing happened in 2020 when the pandemic hit). It makes sense as the companies aren’t as profitable as the demand of steel may be down. At the same time, steel isn’t going anywhere anytime soon as it is a commodity used across many industries and products. So eventually the demand picks up and pricing gets better and profitability returns for the steel companies.
When the P/S ratio is the higher range it may be a sign that in the short term the market is hot and pricing of steel is higher (but may not be sustainable). Commodity businesses tend to reverse to the mean since they tend to increase capacity to accommodate for better pricing which inevitability causes each revenue dollar not leading to as much profit. Also since it is cyclical, the high demand for steel may not last over a prolonged period of time.
With cyclical stocks fluctuating between these high and low periods, I try to avoid a big position when the company is trading at historical high P/S ratios and may be more interested when we are coming out of a recession going into a better economy as the demand and profitability both shoot up at a fast pace.
Unprofitable Growth Companies
We have all been there. Staring at a company is in an exciting new industry and they are growing at a good pace. But the company is investing all of their money back into the business in order to scale or grow faster. This focus on growth may mean the company is actually turning a loss! Ew gross.
If you are a Warren Buffett disciple, you may just brush this investment opportunity due to seeing no profits and decide to buy more Coca Cola (KO) stock instead.
In the era of technology companies becoming a larger portion of the economy though, you can miss companies like Amazon who we’re choosing growth over short term profits. Eventually these companies reach scale and the money printer is turned on. With a P/S ratio we can ignore the fact the company may be loosing money now, but it still may be undervalued for a fast growing company in an exciting industry.
If you are looking at similar companies in the same industry, you can get an idea of which ones are trading at a premium or discount to each other. Of course, there is usually a reason why a stock may be trading at a premium. It may be up to you whether or not you agree with the market.
For example let’s compare Home’s Depot vs. Lowe’s. Both companies are in the same industry and run a very similar business model.
Lowe’s trades at a 1.88 P/S while Home Depot 2.89. Is Home Depot really that much better than Lowe’s to trade at such a premium? Looking at the P/S of like companies can give you an idea of the market’s opinion on similar businesses.
This also allows you to decide whether you agree with the market or if you think Lowe’s is undervalued or Home Depot is overvalued. It also can give you a range of acceptable P/S ratios for an industry if you can find even more similar companies and you aggregate all the data over a longer period of time.
The fact that I can get a pulse on the relative value of a company in about 20 seconds is amazing. I don’t have to whip out the excel model and start gathering assumptions for 30 different inputs. All I need is two numbers and I can get a reference point.
Is it less valuable if it is simple? Not necessarily, I think it is just important to understand some of the drawbacks of this simplicity in the following section.
Doesn’t factor in Growth
The formula for P/S ratio is backward looking. If a company is having sales drop off a cliff in the next 5 years, then while the P/S ratio may look good vs. it’s historical range. If you don’t look at the future though, you may be getting sucked into investments or companies that have had their glory days behind them.
That is why if a P/S ratio or really any multiple looks low, your first question should be what does the market know that I don’t know. If you understand why it is trading at a lower multiple and you think it can be solved and is more of a short term issue, then you may have found a hidden gem!
Debt is Ignored
So let’s say a company has a P/S ratio of 3 and the next year it is 2. Well it looks like it’s on sale! What happens though if the same time the company has mounting debt that is crushing the company slowly and is becoming a larger problem. Eventually a company that is highly leveraged will have to face the music and pay it down which will eat into it’s ability to grow or lower profits.
P/S ratio doesn’t even consider what is happening on the balance sheet as it is only looking at the revenue side. Therefore using P/S ratio alone isn’t ideal.
Can’t Compare Across Industries
Company X has a P/S ratio of 1 while Company Z is 8. The first assumption would be that company X is the better deal amongst the two companies. What you don’t know though is the profitability and industry that these companies are in.
It turns out Company X is a Exxon Mobil (XOM) while Company Z is Facebook (FB).
Being an energy company focused on commodities, Exxon’s expected growth as an industry is smaller and they have lower profitability for each dollar of revenue generated. Facebook on the other hand is growing at a faster pace along with much higher operating margins.
Comparing the two P/S ratios is like comparing apples to oranges and you would end up investing in only slow to negative growth legacy companies 🙂
Value of P/S Ratio on It’s Own (Is the ratio high? or low?)
So a company has a P/S ratio of 3. Fantastic! Or wait is that good? Should it be 1? or is 3 a fantastic deal and I should be throwing all my money at this once in a lifetime opportunity?
This is the problem you can run into with using P/S ratio. At the end of the day we have to have a way to analyze if the number we are looking means the company is undervalued, fairly valued, or overvalued.
There is a few approaches that can be used.
Peers – If there is similar companies, you can see as a group where the specific company you are evaluating lands amongst its peers.
Historical range – You can compare your company against it’s prior self. If the dynamics of the market in the past was similar and the company is trading at a lower multiple, then it may be trading at a good value.
Industry – Looking at historical averages for P/S ratio for the industry the company you are looking at is in may also give you insight to the relative value. For example, if home builders have historically traded around 1.06 P/S ratio and the stock is at 5, why would that be? Is that home builder way more profitable than peers? Is it expected to grow at a much higher rate than peers?
When I Use P/S Ratio
I personally use P/S ratio when it comes to cyclical stocks as well as growth companies. If a company is more well established and has consistent cashflows, I would rather use a discounted cashflow model or a multiple valuation that factors in the profitability.
With a more detailed valuation method you are calculating the intrinsic value which can be compared to the current market cap. This allows you to see the potential returns compared to your projected fair value along with the ability to calculate your margin of safety (you can be off with your assumptions and reduce your downside risk).
Looking at a stand alone P/S ratio is way to establish relative value and a comparison to like companies, but it is a tradeoff between simplification and speed over the more detailed approaches to valuations that factor more than just trailing twelve months of revenue.