3. What is the price to sales ratio( P/Sales)?

For some investors is the king of ratios, for me it´s only the prince. The price to sales ratio is one of the more simple ways to decide when  a share is cheaper or expensive and it can be used as a good predictor of the future share price performance. One of its great benefits it is a nice simple ratio, because all you do it´s to take the price of the share over the sales per share or Market capitalization over the total shares. The market cap: it´s the number of share times the current price of the share. And you can find the net sales in your income statement.

For example if the market cap is $80m and the net sales are $100m then the P/sales is 0.8. So what?

Some studies and investors believe that whether the P/sales ratio is below 1 the share price performance is normally strong and above 1 watch out because you are looking at an expensive stock.

There´s another reason because investors like this ratio, it´s because we are using the net sales instead of profits or earnings which can be manipulate easily manipulate for the CEO of the company. And sales are a little tricky to manipulate. There are times when cyclical companies have no earnings, so the price-sales multiple can be a better indicator of a company´s relative value than the P/E.

Is it perfect? No, there are some drawbacks. First, sales aren´t profits and can still have sales for 100K but earnings below 0. Because if a company is making sales, it doesn´t mean that they are making new money. The second one would be the called "debt trap" It´s totally possible for a firm to generate an increase in sales but a decrease in the market capitalization, maybe because it carries a lot of debt. The problem of this ratio explicitly reveal that you can get a low price/sales ratio, but the reason is the market is worried frankly about that. However there is a way to correct it, using something called the enterprise value (There is a post called "what is an enterprise value" in which we talk about it).

There is another problem about this ratio, because  I wouldn't use it in some sectors such as financial firms, and the reason is the way that they report revenues is a little bit different to other sector.

To sum up, this ratio is telling you how much are you paying for every dollar in annual sales. And even with some problems like the debt or the lack of profitability, is still used by a lot of investors because of its simplicity.