I often see people refer to price/sales ratios (P/S) as a estimate of value, but it makes no sense to me. Perhaps someone can explain why it makes any sense at all to use this ratio. Let me give you an idea what I mean.
Take Walmart, for instance. They bring down $3 to profit (net income) out of every $100 that they take in. It’s the nature of their business to have a low net income margin. That no criticism of Walmart. It’s just the business they are in.
Then look at UBNT (Ubiquiti). They bring down $30 to profit (net income) out of every $100 that they take in. It’s the nature of their business to have a high net income margin. Software companies can even have lots higher net income margins than that.
Walmart will have a very low price to sales ratio because they bring down such a small part of those sales to profit. That doesn’t mean their stock price is cheap, or a bargain.
Ubiquiti could have ten times the price to sales ratio that Walmart has, because they bring so much of their sales down to profit. That doesn’t mean that their stock price is expensive compared to Walmarts.
Price to sales ratios just seem meaningless to me, because companies are so different, and businesses are so different. What counts is what gets to profit, not what comes in the door as sales, and different businesses are totally different.
The only way it seems to me P/S can be useful is if it is ridiculously high. For instance if a company has a price to sales ratio of 100, that’s just plain silly, because even if they brought all of their revenue down to profit (impossible) they’d still have a PE of 100, and if they brought 50% of revenue to profit (very difficult), they’d have a PE of 200.
But comparing normal P/S ratios just seems meaningless to me. I’d appreciate other peoples thoughts on this.
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Saul, my impression is that P/S gained popularity as an alternative to P/E for companies that had no earnings. I guess the assumption is that the company is foregoing earnings in order to grow revenue, so that’s how they should be judged.
Frankly, I’ve never understood why so much weight is put on all of those various ratios and metrics. Every business is unique.
I use P/S in conjunction with revenue growth and profit margins to limit my entry into positions or decide to exit positions. I sold DDD earlier this year when the P/S broke 20 and they did not have the revenue growth or profit margins to justify the valuation. It made sense for me to redeploy the capital into a less risky opportunity.
P/S in context of business performance can be telling.
I look at Price to sales and Price to book value metrics. These metrics are useful in at least three contexts. One, you can compare current P/S with its historical range. This information can be useful for deciding a value point for entry into the stock. Two, it can be used to compare businesses in the same sector, especially for comparing competitors. Three, its useful for looking at businesses that have not reported any earnings.
I sold DDD earlier this year when the P/S broke 20 and they did not have the revenue growth or profit margins to justify the valuation.
This is a good practical example of what I was talking about with a “ridiculous” P/S ratio. With a P/S ratio of 20, if they consistently brought $20 out of every $100 in sales to profit (which is difficult for a manufacturing company), they’d still have a PE of 100. Too high for me.
Another use P/S is for companies that keep investing in their business to grow and thwart competition, and in the process obscure the earning power of the business. AMZN is a classic example in this category. AMZN evaluated on P/E ratios (or just earnings) will totally miss the world conquering capabilities of the business. However, those who invested by studying AMZN sales and P/S ratios have made a killing on their investment!
Two things: 1. Happy Fooliversary - nice balloons today and 2. Thank you very much for your thoughtful posts of late - I have found them to be very helpful and educational.
Thanks Chris. I am glad you have found some of my posts interesting.
I am working on a writeup on Mazor Robotics next. Expect to have it done by Friday. Work’s been busy so no time really to spend on researching ideas. I am also falling behind on my board readings!
Happy 3-Year Fool anniversary Anirban…!
Happy Fooliversary! I mostly quietly really appreciate your posts on whatever board I find them. Keep it up.
Ken Fisher, who popularized the Price/ Sales ratio,says it doesn’t work anymore.