In past articles, we have looked at the P/E ratio and the PEG ratio. Another ratio that is important but not so popular is the P/S ratio. P/S ratio is calculated by dividing the market capitalization by the company’s trailing twelve month sales.
P/S ratio is especially important for companies which are exhibiting revenue growth but still not profitable. Such companies are hard to evaluate using P/E and PEG because they are showing losses and hence their P/E ratios are negative. The smaller this ratio (i.e. typically less than 3.0) is usually thought to be a better investment since the investor is paying less for each unit of sales. However, sales do not reveal the whole picture, as the company may be unprofitable with a low P/S ratio. A good way to look at the P/S ratio is to use it together with %Sales Growth (i.e. last 4 Quarter sales compared to the last-to-last 4 Quarters). A low P/S ratio along with atleast 30-50% sales growth could be used to find stocks with future growth potential. A good way to see if a company is undervalued is to compare the P/S ratio with that of an industry or sector.
Often times, the stocks that fall into the category of negative earnings are growth stocks that are focusing more on revenues than earnings and not yet profitable.This is mostly found in emerging high-tech companies, e.g. during the internet boom of the late 1990s in the US, one would have missed out on the hottest stocks like Amazon and Yahoo, had one focused only on P/E, because companies like Amazon were only focusing on building their sales at the expense of profits. A simple strategy of using P/S ratio along with their %Sales Growth would have proved to be very successful in such a case. One just needs to be careful in focusing on the right companies though, because unlike Amazon not all companies were successful in turning profitable after years of revenue growth.
If you are an Investar user, and want to use the strategy outlined above, you should look for stocks that have a Bullish sign for both P/S and % Sales Growth.