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How to Think About Lofty Price-to-Sales Ratios

By Brian Withers and Matthew Frankel, CFP® - Mar 13, 2021 at 2:19PM

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How high is too high?

Often, the go-to metric for investors to judge how "expensive" a stock is compared to its peers is the price-to-earnings ratio. But what if a company is investing all of its profits into growing the business? For growth investors, the price-to-sales ratio is a good way to get an idea of the value of a stock that doesn't have a positive bottom line. On a Fool Live episode recorded on March 3, Fool contributors Brian Withers and Matt Frankel discuss how to think about stocks that have high-double-digit price-to-sales ratios.

Matthew Frankel: [A viewer asks...] "What is an average or normal price-to-sales ratio? Because I often quote a price-to-sales ratio with these growth companies just because they don't have earnings to talk about, so it's a good metric to look at." The answer is that it depends.

It depends on the industry, it depends on the growth rate. If you look at some value stocks like General Motors, for example, trades for less than one times sales. That's a value stock, it's because it's a relatively low-margin business, it's a value stock, not a growth stock.

On the other hand, there are some growth stocks that trade for over 100 times sales and it's completely justified. The way I like to use the price-to-sales ratio is in combination with the company's growth rate. The higher the company's growth rate, the more of a price-to-sales ratio it can justify. I like to look at a few different growth stocks, just look at each one's growth rate, price-to-sales and see which one's relatively cheap or expensive. That's one of the components of when I evaluate growth stocks.

This is coming from the Fool's resident value investor.

Brian Withers: Yeah, there you go. Well, what's interesting is, and I'm glad we picked up this question, the S&P price-to-sales ratio is about 2.8. So [laughs] when we're talking stuff in the double-digits, in the 20s and 30s, just recognize that's a significant premium to what the overall market is.

Really, it doesn't make sense to put an airline like American Airlines, and I don't know what their price-to-sales ratio is. I suspect it's very low, versus Twilio (TWLO 1.19%), which doesn't have any capital-intensive business the airline has. It doesn't hire mechanics, and get spare parts, and buy all these airplanes, and maintain them over time. They release software and immediately, that software goes all over the world, and they have really high margins which allows them to continue to invest in their business.

Some of these SaaS companies, their price-to-sales ratios are going to be at certainly premiums to the market, where my rule of thumb is, if you're growing 40 percent year-over-year annually, I would hope that your price-to-sales ratio is less than 40. That's just my rule of thumb.

That's probably an expensive stock, but as you're looking at different stocks, make sure you compare it to their growth rates. Certainly, look at their cash burn as well. All the companies that we talked about here have [a] pretty solid balance sheet. But you don't want to have them running out of cash in the next 12 or 18 months. That's not a good situation.

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Stocks Mentioned

Twilio Inc. Stock Quote
Twilio Inc.
$103.03 (1.19%) $1.21
General Motors Company Stock Quote
General Motors Company
$35.40 (-1.99%) $0.72
American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
$16.26 (-2.92%) $0.49

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