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The sales impact

The sales impact

Continuing the series on financial concepts, MONEY TODAY explains how the price to sales ratio can help an investor know if a stock is worth buying.

Most valuation metrics depend on earnings to analyse a company. If the widely used PE ratio uses EPS, the advanced EV/EBITDA ratio uses operational earnings. However, earnings can be arithmetically boosted or suppressed by changing accounting policies. To avoid such changes, Kenneth L. Fisher, a noted stock market guru, developed a concept called price to sales ratio, or PSR, which uses sales as a primary parameter in evaluating a company. According to Fisher, sales of good companies remain more or less constant over a period of time, are relatively difficult to manipulate and are less prone to accounting gimmicks.

The price to sales ratio is calculated by dividing the market price (of the stock) by the sales per share. It can also be calculated by dividing the market capitalisation of the company by one-year sales. The PSR is ideal for valuing companies in the investment phase and is widely used to assess the value of cyclical stocks. The ratio shows the number of years in which the company’s sales equals its market capitalisation. If the PSR of a company is 2, it implies that it will take 2 years for the company’s sales to reach its market capitalisation.

Generally, the lower the ratio the better it is. This is because even a slight improvement in profit margins can significantly augment the earnings of low PSR stocks, which will then drive up their stock prices, as investors react positively to the earnings.

For non-cyclical and technology stocks, a PSR of less than 0.75 is highly desirable, whereas stocks with a PSR of 0.75-1.5 are considered good picks. Stocks with a PSR of over 3 are considered risky. For cyclical stocks, a PSR of less than 0.4 is most desirable. While stocks with a PSR of 0.4-0.8 are investment worthy, avoid cyclical stocks with a PSR of over 0.8.

The PSR has certain limitations. It varies widely across industries, which makes it difficult to compare companies in different sectors. Also, it does not distinguish between a levered and an unlevered company. A firm may have a low PSR, but could be on the verge of bankruptcy due to high interest costs. Furthermore, the ratio does not give any idea of the company’s profitability and cost structure. Therefore, the PSR should always be considered with other factors like debt-equity ratio, earnings growth and free cash flows.