Course 305: Price/Book and Price/Sales Ratios
Price/Sales Ratio
 In this course 1 Introduction 2 Price/Book Ratio 3 Price/Sales Ratio

Perhaps the biggest advantage of the price/sales ratio is that it is based on the difficult-to-manipulate sales figure. Also, because sales are generally more stable than earnings, price/sales (P/S) can be a good tool for sifting through cyclicals and other companies with fluctuating earnings. Take a look at chemical company Du Pont DD. Although its P/E was as low as 13 and as high as 29 between 1994 and 1999, its P/S stayed between 1.7 and 2.7. The P/S ratio is also helpful in evaluating firms with negative earnings--which is why it's become such a popular tool for evaluating Internet stocks, which are often far from making money. Sounds pretty good, doesn't it? Bear in mind, however, that whereas a dollar of earnings means essentially the same thing regardless of what company is producing it, the value of a sales dollar varies quite a bit from firm to firm. This is because companies' profit margins, or the efficiency with which sales are translated into profits, are highly variable. A software company like Microsoft MSFT is able to convert every dollar in sales into more than 30 cents of profit, but computer hardware manufacturer EMC EMC is only able to wring about 20 cents in profits from each dollar of sales. So, each dollar of Microsoft's sales is more valuable than each dollar of EMC's. This is why, even though the two companies have roughly comparable growth rates, Microsoft's P/S ratio is 27 and EMC's P/S ratio is a much-lower 16. The strong effect of profit margins on P/S ratios is why they tend to vary tremendously across industries. For example, the retailers in Morningstar's stock database had an average P/S of just 0.8 at the end of 1999. That's because the average net margin for these companies is only 4%--only four cents of every dollar they make in sales translates into profits. On the other end of the spectrum, the average software company in our database keeps 15 cents of each sales dollar. It shouldn't come as a surprise, then, to find out that software companies have a P/S of almost eight--their sales dollars are simply worth a good deal more than those of the retailers are. Because both price/book and price/sales ratios aren't really comparable across industries, they are best used when comparing similar companies with each other or the current valuation of a particular company with its historical levels. As long as you stick within these boundaries, these ratios are a useful addition to the toolbox of every investor.

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