As an investor, it’s important to compare the value of stocks to determine which stocks are worth investing in. The PSR ratio is one such metric which will help the investor determine high valued stocks.
What is Price-to-Sales Ratio?
Price-to-Sales Ratio is a valuation metric developed by Kenneth L. Fisher, a noteworthy stock market guru. It’s a concept that uses ‘sales’ as a primary parameter to evaluate a company. The PSE metric is based on the fact that sales are far more stable when compared to earnings which keep fluctuating. Similar to the P/E ratio, it is based on the top line rather than earnings per share. The PSE ratio will remain uninfluenced even with a change in the number of shares outstanding from share repurchases.
Why is it important?
The PSR ratio is important for analysing the fundamentals of a company. It helps avoid anomalies which result from arithmetically boosting and suppressing earnings, by manipulating or altering earnings and profits. Since investors may raise expectations to unrealistic levels for companies with strong early growth, a fall in earnings may subsequently result in a fall of stock prices especially when investors sell hurriedly.
The PSR metric is based on the fact that sales are far more stable when compared to earnings which keeps fluctuating.
How does it help to analyse fundamentals?
The PSR ratio denotes how much the stock market values the sales of a company. It assigns value to growth stocks irrespective of whether they have made profits yet or not or whether they are struggling with minor difficulties in their operations. It helps to determine if a company is overvalued or undervalued especially if profits are yet to be earned.
Calculation and Ideal Value of PSR
The formulae for calculating the PSR ratio for a stock is as follows:
PSR = Stock price/Sales per share
PSR = Market cap/Annual sales
The ideal value of PSR is one that’s relatively a lower ratio. For non-cyclical and technology stocks, the ideal value of PSR is below 0.75. Also, good stocks are considered those with PSR between 0.75 and 1.5. If the PSR value is greater than 3 for stocks, they are considered risky. For cyclical stocks, the ideal value of PSR is less than 0.4 and not higher than 0.8. Lastly, for investment-worthy stocks, the ideal value of PSR is between 0.4-0.8.
Limitations of PSR
- The value of PSR varies depending on sectors and industries which makes it difficult to rely on this metric for comparing companies.
- PSR cannot differentiate between leveraged and unleveraged companies.
- A low PSR may even be observed for bankrupt companies.
- The PSR ratio does not signify the profitability or cost structure of a company.
- PSR should always be viewed in conjunction with other metrics like debt-equity ratio, earnings-growth and the free cash flow.
- PSR also falls short since sales cannot always be treated the same for every company.
- Sales revenue figures can be unreliable at times which makes PSR a limiting metric.
- Analysing sales must occur in conjunction with a careful analysis of profit margins and by comparing the finding with other companies in the same sector.
All valuation techniques including calculation of the PSR value should be evaluated in conjunction with other metrics to determine the value of a company. Just going by the absolute or face value of PSR, one can get a false indicator of value. It is not to be viewed in isolation.