The price-to-sales ratio (P/S) can be a handy measure to use, instead of a price-to-earnings (P/E) ratio, if you're dealing with a company that has no earnings. If there are no earnings, you can't calculate a P/E, but as long as a company has sales, or revenues, you can calculate a P/S. (And besides, if a company has no revenues, why the heck are you looking at it?!)
The P/S takes the market capitalization of a company and divides it by the past 12 months' revenues. Remember that the market cap is the current value that the market is giving the company, arrived at by multiplying the current share price by the number of shares outstanding.
Take a look at up-and-comer XM Satellite Radio (Nasdaq: XMSR ) . XM has 258 million shares outstanding, priced at $21.80 a share (as of market close on March 29, 2006), so its market capitalization is $5.62 billion. The company had $558 million in sales over the past four quarters (as of Dec. 31, 2005), so its P/S would be 10.1 ($5.62 billion divided by $558 million). Compare the P/S with sales growth. A high P/S isn't necessarily bad if sales are growing rapidly -- and XM's compound annual revenue growth has been a whopping 202% over the past three years.
The P/S is especially handy with start-ups, small-cap companies, and unprofitable firms; you can use it to determine how a company is faring relative to its competitors. XM is still unprofitable, but it has a P/S of 10.1. You can compare this with the P/S ratios of its peers -- competitor Sirius Satellite Radio (NYSE: SIRI ) has a P/S of almost 28, but its compound annual sales growth rate has reached 570% over three years.
In addition, there are always years during recessions when companies in a certain industry, such as the auto industry, are unprofitable. This doesn't mean they're all worthless and lack an easy means of comparison. You can simply apply measures such as the P/S instead of the P/E -- sizing up how much you're paying for a dollar of sales instead of a dollar of earnings.
Despite its usefulness, though, the P/S should never be the only number you crunch.
The P/S can sometimes give you a nice context for a company's value relative to its industry peers, but while sales growth is great, revenues must be transformed into meaningful and rising earnings to make shareholders happy. Some companies have massive and growing revenues but little earnings to show for it. How much a company earns from its sales will eventually drive the value of the business and the stock over the long term, along with its cash position and free cash flow. Learn how you as an investor can measure value in other ways by reading more about valuation.
XM Satellite Radio is aMotley Fool Rule Breakersrecommendation. Selena Maranjian, Shruti Basavaraj, and Adrian Rush contributed to this article.