Price to Sales Ratio: A Poor Indicator of Value
The price to sales ratio is a marginal valuation ratio at best. It is really an offshoot of an antiquated concept of valuing a business. In the past, one of the more common methods to value a business deal was to use a multiplier of sales. It is still used today by many organizations to value a book of business such as a property and casualty insurance agent or the entire firm. If an agent wants to retire, the agent sells his book of business based on a multiple of the revenue he generates. The idea is that the buyer will receive a return on future sales to compensate the buyer for the money paid to buy the book of business.
The price to sales ratio used with business ratios is similar. Simply stated, the price to sales ratio is the entire market value of the company (the price) as a function of revenue (sales). To illustrate, let’s look at some common price to sales ratios for various large companies traded in the market.
Market Price/Sales
Name Capitalization Sales Ratio
Verizon $242B $131B 1.85
3M $124B $33B 3.76
Exxon Mobile $341B $279B 1.22
Target $42B $75B .56
Notice the wide latitude of results?
As with all business ratios, there is no correct value nor a threshold to state whether the result is good, bad or indifferent. The reality is that the ratio can only be used to compare one company against a similar company. In the above illustration, 3M is a chemical and consumer products manufacturer; whereas Target is involved in retail sales. Their price to sales ratio results are vastly different and as such, the ratio can’t be used to compare two dissimilar companies.
This chapter explains the ratio in-depth by first exploring the concepts of the price to sales relationship. In the second section below, the author explains the differences between a trailing ratio and a leading ratio. In addition, it will cover the best usage of both. Finally, this chapter in business ratios covers why this ratio has little value and is only marginally contributive in a business investment model. The price to sales ratio is only useful in a highly defined set of circumstances and must be used properly to gain benefit from the outcome.
For the reader, understanding the concept of the price to sales ratio is the foundation for a full appreciation of the limitations of this ratio.
Price to Sales: Concepts
Value is defined as the ‘worth’ of something. In business, it is quantified in the form of dollars. A value investor wants to buy low, i.e. buy stock that is actually worth more than the current sales price. Keep this in mind as the price to sales concepts are explained here.
In business, calculating worth is difficult, easy solutions include book value or liquidation value. However, it is nearly impossible to find stock sold on the public market currently priced below book or liquidation value. Prior to the United States highly regulated stock market exchange system started after the 1929 market crash, stocks were traded with limited public information available. Worse yet, independently audited financial statements were non-existent. Stocks were traded based on indicators. One of those indicators was sales. Thus, the price paid for a stock was often derived by sales. It was thought that sales indicated market share and therefore the ability to generate profits.
You would be a fool to base your purchase solely on sales. Yet, today many small business exchanges of ownership are tied to sales. Read a small business shareholder’s agreement, a common clause in this document is the price formula a buyer (an existing owner) must pay to buy out another owner. This price formula is almost always a function of sales, not profitability, purely sales.
Given this, why would a modern-day investor base or give a lot of weight in the decision model on the price to sales ratio? To answer this, the formula must be explored first.
Formula
There are actually two formulas. Don’t roll your eyes just yet, it will make sense. The formulas are merely a relationship to each other. Both will end up with the same result. The most commonly used formula is:
Price to Sales Ratio = Market Value of the Company
Sales for the Prior Year
Market value refers to market capitalization which is merely the number of shares in the market currently times the price per share. It is the value the market believes the company is worth. For example, on August 2nd 2018, Apple was worth over a trillion dollars.
Another company coming close is Amazon. On 04/17/19, the stock was trading for $1,870 per share with 491.2 million shares in the market. Multiple the two values and the result is $918,544,000,000 ($918.5B). Amazon sales for the prior year were $232.9B. Thus, Amazon’s price to sales ratio is:
Price to Sales Ratio = $918.5B = 3.94
$232.9B
The second formula is merely a step down of the overall formula. The second formula is on a per share basis. Thus, it is the current market trading price divided by the sales per share for the company. For Amazon it is:
Price to Sales Ratio = $1,870 = 3.94
$474/Share
Look at the result above. Let’s put on our thinking caps for just a moment. If you look again, notice the current market price for a single share is $1,870. Each share generates a mere $474 in sales. If Amazon’s costs were ZERO, it would take 3.94 years of sales at this level to earn enough cash for Amazon to buy back all the stock. YES, that is right; the price to sales ratio also serves as a reminder that even under the most optimum conditions, it identifies the absolute earliest you could get your money back. Amazon’s actual net profit margin is 4.33%. At 5% net profit margins per year and assuming Amazon paid out the entire amount as dividends, then it will take 79 years to get your $1,870 back with no capital gain.
This means, the lower the ratio, the more likely the investment is lucrative. Ratios less than 1:1 are customarily more desirable. Remember, the price to sales ratio is a valuation indicator; the lower the ratio the more valuable the investment. As a value investor, you want desirable valuation ratios.
Thus, there are two concepts related to the price to sales ratio the reader must remember:
- The price to sales ratio has little to any value in a business decision model as it is based on outdated usage.
- The lower the ratio value the more lucrative the investment; ratios of less than 1:1 are desirable; the lower the better.
An interesting aspect of the ratio formula. It is most frequently used in the past tense. It refers to sales from the past. There is another variation of this ratio.
Trailing and Leading Price to Sales Ratio
The most common usage of the price to sale formula relates to the most recent 12 months of sales. This is referred to as the trailing twelve months or TTM for short. When reading the ratio’s results, it is inferred that the result is based on the previous twelve months of sales.
However, sometimes the ratio’s results are qualified by stating that the ratio is LTM or FTM. This means the ratio is based on leading twelve months or future twelve months. The sales value is substituted with the estimated sales for the future. Let’s explore the difference.
Currently Netflix has a market valuation of $157B (04/17/19) and the most recent twelve months of sales are $15.8B. The price to sales ratio is:
Market Capitalization = $157B = 9.9:1
Sales $15.8B
Netflix is currently experiencing a high growth rate in sales. Analysts anticipate a 35% increase in sales over the next year. Therefore, future sales are estimated at $21.3B. Now, let’s look at the results:
Price to Sales Ratio (LTM) = $157B = 7.37:1
$21.3B
Note the significant difference in the ratios. In general, the LTM should be lower than the current price to sales ratio. It is important for the reader to look for the qualifier for the ratio, don’t substitute the past with the anticipated future.
In general, older more mature companies use the current price to sales ratio (based on history) and not the leading indicator. High growth companies tend to utilize the leading formula when indicating results. Again, determine the source of the information; trustworthy sources will use the historical results and always indicate otherwise that the formula is a result of using future sales.
The leading formula results are commonly used by investors that seek out high growth investments. Value investors tend towards conservative values in order to get best results in their business decision models.
Best Application of the Price to Sales Ratio
In general, this ratio contributes very little value in determining a stock buy or sell decision. However, it does have utility.
In highly stable companies where profits are normal and consistent for many years in a row, the price to sales ratio comes into play. Sometimes, good companies will see sales increase beyond marginal amounts. Often this is driven by quality of product or service. When sales increase more than 20% in a given year and its anticipated that sales will again continue the same pattern for several years, this ratio now becomes important. Why? Let’s find out.
Medtronic is in the medical technology field, specifically medical equipment. Sales over the last 5 years are as follows:
2014 $17.0B
2015 $20.2B
2016 $28.8B
2017 $29.7B
2018 $29.9B
From 2014 to 2016 the company grew its sales 69%. The company experienced positive earnings per share per quarter for the last 12 years making it a highly stable business. Medtronic’s price to sales ratio table over the last 6 years is as follows:
End of Fiscal Year Ratio
2013 2.6
2014 3.2
2015 3.6
2016 3.7
2017 3.8
2018 3.6
Notice how the ratio mimics the increase in sales from 2014 to 2016 and then levels off as sales leveled off from 2016 to 2018. From 2014 to 2018, the stock price doubled, thus the market capitalization doubled. Remember one of the concepts learned above, the more stable the company, the more likely the price to sales ratio will stabilize.
But the real key is that if at the end of 2013, had the investor compared the TTM to the LTM, the investor would discover a significant gap (from 2.6 to 3.2) indicating value. Indeed, value did occur, at the end of fiscal year 2013, the stock price was $47 per share and it grew to $58 a share in 2014; a direct reflection of the TTM and LTM results. Again, the only reason those results were reliable back in 2013 would be because of the highly stable results the company has generated over many years.
Therefore, the price to sales ratio has some marginal value when the following conditions exist:
- Long-term earnings stability (>10 years)
- There exists a significant spread (>10%) between the TTM and LTM for the price to sales ratio.
- The current price to sales ratio is less than or equal to other similar companies.
It is within this narrowly defined set of conditions that the ratio can be valuable to the user. Other than this, the ratio’s value can only provide validity in the decision model if using a graph of the ratio over an extended period of more than five years.
Summary
In this chapter, the reader learned of the following concepts related to this business ratio:
- The ratio had greater reliability on its results prior to the 1929 stock market crash and is marginally valuable under current market reporting and compliance requirements.
- The lower the ratio, the greater the chance the ratio indicates value with the investment. A price to earnings ratio less than 1:1 is worth investigating especially if the company has a history of stable earnings and low risk.
- The price to sales ratio is more informative when comparing the trailing and leading results; the greater the difference, the more likely the investor has value in the investment.
As with all business ratios, use a historical graph for each ratio to evaluate the investment. In addition, ratios can only be compared to similar sector companies or industries. Finally, NEVER base a decision on a single ratio; a good investor will utilize more than 12 ratios to evaluate the investment. ACT ON KNOWLEDGE.