The price/sales (P/S) ratio is figured the same way as P/E, except with a company's annual sales as the denominator instead of its earnings. An advantage to using the P/S ratio is that it is based on sales, a figure that is much harder to manipulate and is subject to fewer accounting estimates than earnings. Also, because sales tend to be more stable than earnings, P/S can be a good tool for screening cyclical companies and other companies with fluctuating earnings patterns.

P/S = (Stock Price) / (Sales Per Share) = (Market Capitalization) / (Total Sales)

When using the P/S ratio, it is important to keep in mind that a dollar of earnings has essentially the same value regardless of the level of sales needed to create it. Meaning, a dollar of sales at a highly profitable firm is worth more than a dollar of sales for a company with narrow profit margins. This means comparing price/sales is generally useful only when comparing companies in similar industries.

To understand the differences across industries, let's compare grocery stores with the medical-device industry. Grocery stores tend to have very small profit margins, earning only a few pennies on each dollar of sales. As such, grocers have an average P/S ratio of 0.5, one of the lowest in Morningstar's coverage universe. It takes a lot of sales to create a dollar of earnings at a grocery store, so investors do not value those sales dollars very highly.

Meanwhile, medical-device makers have much fatter profit margins. Relative to the grocer, it does not take nearly as much in sales for a medical-device company to create a dollar in earnings. It is little wonder the device makers have a high average price/sales ratio of 5.0. A grocer with a P/S ratio of 2.0 would look quite expensive while a medical-device maker with the same P/S could be dirt-cheap.

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