When Should the Price-to-Sales Ratio Be Used to Evaluate a Stock?

Investors need ways to compare stock prices, to determine which stocks may be undervalued and therefore a good investment prospect. Different parameters are used to make that determination.

The price to earnings (P/E) ratio is often used as a measure of how expensive or how cheap a stock is, based on the company's earning capacity. This ratio is often expressed as a multiple, and is calculated as the total market capitalization of the stock - the share price times the total number of shares outstanding - divided by the company's net earnings for the past year. It can also be calculated on a per-share basis by dividing the market price per share by the earnings per share. By expressing the price of a stock in terms of a multiple of the company's earnings, the prices of different stocks can be compared.

When is the price to sales ratio useful?

There are many factors affecting net earnings, such as profit margins, expenses, and unusual events, such as mergers and acquisitions, which can have a significant effect on net earnings from one period to another. Another consideration is how to evaluate a start-up company that is not yet generating earnings, but has significant growth potential and is worth considering as an investment.

In Investopedia, Ben McClure points out that the price-to-sales ratio can be a valuable indicator in a highly cyclical industry, where there are years when earnings are down in general. During these periods the price-to-earnings ratio can indicate that the stocks of companies in the industry have decreased in value, possibly leading to the conclusion that they would not be a good investment. But the price-to-sales ratio can be used as a way to compare similar companies in that industry based on the strength of their sales and their potential for generating earnings in the future.

How to calculate the price to sales ratio

The price to sales (P/S) ratio is calculated by dividing a company's current market capitalization by the past 12 months' total revenue. If you have revenue per share information, the P/S ratio can be calculated as the share price divided by revenue per share.