The Price-to-Sales Ratio (PSR) 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. No earnings means you can't calculate a P/E -- but as long as a firm has sales, or revenues, you can calculate a PSR. (And if a firm has no revenues, why the heck are you looking at it!?)
The PSR takes the market capitalization of a company and divides it by the last 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.
Imagine Iditarod Express (ticker: MUSHH), famous for its slogan, "when it absolutely has to get to a remote corner of Alaska in the next few weeks." If MUSHH has 10 million shares outstanding, priced at $10 a share, then its market capitalization is $100 million. If it had $200 million in sales over the last four quarters, its PSR would be 0.50 ($100 million divided by $200 million equals 0.50). Compare the PSR with sales growth. A high PSR isn't necessarily bad if sales are growing rapidly.
The price-to-sales ratio is especially handy with start-ups, small-cap companies, and unprofitable firms. Assume that Iditarod Express lost money in the past year but has a PSR of 0.50 when its peers have PSRs of 2.0 or higher. If it can turn itself around and start making money, it's likely to have substantial upside potential if it can match competitors' profit margins. There are some years during recessions when none of the auto companies are profitable. This doesn't mean they're all worthless and there's no way to compare them. You can just apply measures such as the PSR instead of the price-to-earnings (P/E) ratio. Measure how much you're paying for a dollar of sales instead of a dollar of earnings.
Despite its usefulness, the PSR should never be the only number you crunch.
The PSR 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.
There are drawbacks to the PSR, though. Read about them in this article.
