UK Accounting Glossary
Price-to-Sales Ratio (P/S Ratio) is a valuation metric that compares the share price to the sales (revenue) per share.
The price to sales ratio (PSR) is computed as the Stock Price ÷ Sales Per Share.
The price to sales ratio gained popularity among some analysts during the Internet bubble. They used the price to sales ratio to justify high stock prices for the many Internet companies with no earnings. But there are also more salutary reasons for using the price to sales ratio. Sales are less subject to accounting manipulation than earnings, so the price to sales ratio has this benefit over the better-known price to earnings ratio. Some analysts also argue that a low price to sales ratio is a good indicator of firms with prospects of rapid price appreciation. Their reasoning is that, if a company has a low price to sales ratio, even a small increase in margins will significantly raise earnings per share. The price to sales ratio features significantly in the work of money manager James O’Shaughnessy, which argues that a stock with a low price to sales ratio and high “relative strength” (a measure of momentum) will outperform other stocks.
There are three versions of Price-to-Sales Ratio that analysts often use.
As with all valuation techniques, sales-based metrics should not be examined in isolation. A low Price-to-Sales Ratio could indicate unrecognized value provided other criteria such as low debt levels and growth prospects are in place. However, Price-to-Sales could also be a “value trap”.
A low Price-to-Sales Ratio can also be used to screen for growth stocks that have suffered a temporary setback. Sometimes a minor tweak to operating efficiency can turn a money-losing business with low P/S Ratio into a profitable company.
In highly cyclical industries such as semiconductors, there are years when many IC companies do not produce any earnings. In such a situation, investors can screen stocks based on Price-to-Sales instead of P/E Ratio. Price-to-Sales can be used for spotting recovery situations.
A company with no debt and a low Price-to-Sales metric is more attractive than a company with high debt and the same Price-to-Sales Ratio. At some point, the debt will need to be paid off, so there is always the possibility that the company will issue additional equity. These new shares expand market capitalization and drive up the Price-to-Sales Ratio.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Price-to-Sales Ratio is such a factor, having been correlated with past stock returns for many years and also expected to be correlated with future returns.
The P/S Ratio exhibits good quantitative characteristics when analyzed using both short and long investment horizon. The investment horizon also referred to as “rebalance period”, is the period of time stocks are held prior to refreshing the portfolio holdings. The Price-to-Sales Ratio achieves good results with weekly, monthly, quarterly and yearly rebalance, making it a valuable fundamental factor.
Ideally, the performance spread should be “monotonic”, meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, the stocks from the Russell3000 Index were sorted into quintiles based on P/S Ratio, then evaluated over the 10 year back-test period 2005-2014 with a 3 month rebalance period.
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This glossary post was last updated: 6th February 2020.