BS Primer: When to use Price/Sales to value companies?

One of the most popular measures of valuations in the stock markets is the P/E ratio or the Price/Earnings ratio. It essentially measures what the market is willing to pay for every rupee earned by the company. For example, if the P/E of a company is 15 then it means that the market is willing to pay Rs 15 as the market price for every earned by the company in the form of EPS. P/E keeps changing over time. For example, when the growth prospects of a company improve or when its ROE improves, the P/E of the company is automatically upgraded. But what do you do in case of loss-making companies?

Obviously, the P/E will be negative but that is not practical as nobody can pay negative for a stock as the minimum value of any company has to be above zero. The point is that P/E will not be applicable in such cases. The other option is to use EV/EBITDA, which is quite common among capital-intensive companies and long gestation projects where it takes to generate net profits. The other option is to consider the Price/Sales ratio instead of the P/E ratio. Let us look at what is the P/S ratio and when it can be applied. 

What is the Price/Sales ratio all about?

The P/S ratio is basically what the market is willing to pay for every rupee of sales generated. In case of services, one can look at revenues as a proxy for sales to calculate this ratio.

Price/Sales ratio = Market price of the stock / Full year sales per share

Alternatively, it can also be expressed on a full value basis as…

Price / Sales ratio = Market cap of the company / Net sales of the company

That brings us to the next two questions; when is P/S ratio applicable and what is a good price to sales ratio? Do we have industry level benchmarks and country level benchmarks that can be applied? What should be the price to sales ratio for growth companies and what should it be for value companies? Since P/S only talks about revenues without looking at profitability, is it meaningful at all or is it just a mirage?

Yes, there are conditions when the P/S ratio can be actually useful…
 

P/S ratio cannot be applied as agnostically as the P/E ratio can. In fact, P/E can be used to compare across companies, sectors and also across geographies. There are some specific conditions where the P/S ratio can be really meaningful.

• Price / Sales measures what the market is willing to pay for every rupee of sales that are generated per share. In case of high growth sectors where the company is literally buying market share through lower prices, the P/S ratio can be useful as a valuation add-on measure. A combination of high growth in the sector and the low P/S ratio can be a good starting point to pin down a future stock market star.

• How do we put our finger on the P/E ratio of a cyclical sector like steel? The P/S ratio can be useful in such cyclical sectors. Typically, steel and aluminium go through long up phases and prolonged down phases. Profitability can move from high profits to large losses. P/E can be quite misleading in such cases. P/S could be a better benchmark.

• How do we measure valuations when the sector is undergoing a major disruption? Self-driven cars versus auto segment; alternate energy versus power; e-commerce versus retail; are all cases in point. There could be disruptive growth but that will take some time to translate into sales and much longer to translate into profits. As the sector is being disrupted the impact on sales is going to be substantial. P/S ratio will make a lot more sense in such cases.

• One of the key advantages of the P/S ratio is that even if profitability parameters cannot be applied, the efficiency parameters can still be applied. Even when the company in question is not making profits, the P/S ratio and Sales/assets ratio can still be calculated and that acts as a good proxy for the P/E ratio.

• Profits can be manipulated but the sales figure has an audit trail and is harder to manipulate. In case of earnings, there is scope for the company to play around with items like depreciation, interest, and taxes. Sales can be cross-checked as the data on sales is also available at an industry level and association level. One can also cross verify such details through competitors and through dealer sources.

• P/S ratio need not be used in isolation but can be an added checklist item in your valuation sheet. The P/E Ratio has an aspect of performance and also perception. It depends on how you interpret the earnings quality of the company. In the case of the P/S ratio, the scope for perception is much lower. Even as a reality check; P/S ratio is a useful checkpoint.

Remember, when it comes to the P/S ratio, the applicability as a standalone technique is limited. But it can add value when used as an additional checkpoint to other valuation methodologies. In specific cases like loss-making companies, cyclical companies, and disruptive sectors; the P/S Ratio does add analytical value!

(The author is a senior equity research analyst at Angel Broking)