Price to Sales Ratio – Formula, Meaning, Assumptions and Interpretation

Formula

Price to Sales Ratio = Current Market Price / Reported Sales Revenue

Many companies state their revenue after removing the effects of onetime events whereas others continue to state the revenue without any adjustments.

Meaning

The price to sales ratio tells an investor how many dollars they are paying for every dollar that the company has in sales. Hence if the price to sales ratio is 3, investors are paying 3 dollars for every dollar in sales. This needs to be benchmarked against the industry average to understand the context.

Assumptions

As in all market value ratios, there is an unrealistic assumption in price to sales ratio too. The assumption is that sales will continue to behave in the same manner for an extended period of time. However, analysts are not so concerned about sales being absolutely flat for an extended period of time. They are more concerned about the average value of sales for the future periods being the same or higher than it currently is.

Interpretation

• More Sales Mean More Profits: Investors often assume that the company will make more sales and earn the same rate of return that it is currently earning. However, this assumption is against the fundamental laws of economics. Economics state that price must be reduced to achieve a higher sales volume. It also stated that costs decrease when scale increases. Hence the profitability of the company is unlikely to be the same with increasing or decreasing sales volumes.

• More Reliable Than Earnings: Proponents of the price to sales ratio are mostly critics of the price to earnings ratio. They understand the importance of comparing the current market price to fundamentals in the financials of the firm. However, they believe earnings are subject to too much manipulation which can be difficult to detect. Sales on the other hand are subject to less manipulation. The sales figure can only be manipulated if there is a change in the revenue recognition policy. This policy is one of the first that is read by analysts and any manipulation here is easily detected.

• Sales Are Subject To Manipulation Too: There have been cases where sales have been wrongly stated without corresponding changes in the revenue recognition policy. However, these are cases of outright fraud rather than cooking the books. There is very little an investor can do to protect against such frauds.

As an absolute measure, price to sales ratio may not be perfect. However, ration analysis is not about absolute perfection. Price to sales is a better indicator of the fundamentals of the company as compared to price to book value, in the opinion of many critics.