One of the most basic valuation ratios is the P/S ratio. The P/S ratio is equal to a stock's market price divided by its sales per share.
P/S = (Stock Price) / Sales Per Share
The nice thing about the P/S ratio is that sales are fairly cut-and-dried numbers, not subject to much accounting assumption and manipulation like earnings can be. Although firms could use accounting tricks to lift sales, it's much harder to do and far easier to catch. Moreover, sales are not as volatile as earnings, because one-time charges or gains can depress or boost earnings temporarily. Plus, the bottom line of economically cyclical companies can vary significantly from year to year, but sales are a more stable benchmark. Moreover, the P/S ratio can be used for companies that don't have positive earnings.
The relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings by comparing their current P/S ratios with historic P/S ratios. The P/S ratio could also be a helpful tool in analyzing companies in the same industry, particularly when a firm may have unstable earnings or no earnings at all. By 2010, for example, AMR Corp (parent company of American Airlines) had lost billions following the financial crisis and great recession, rending its price-to-earnings multiple useless as a valuation technique. However, comparing UAL’s P/S ratio of 0.1 with Southwest's (LUV) of 0.8 appeared to reveal a substantial pricing discrepancy in the market. However, P/S ratios should be used with caution. In this example, further analysis would indicate that AMR was facing a liquidity crisis and headed to bankruptcy. Meanwhile, Southwest's low-cost structure and fuel hedges have allowed it to deliver operating profits for over 35 consecutive years.
The Drawbacks of P/S >>