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While not quite as useful as the P/E ratio or the P/B ratio as a valuation measure, the price-to-sales ratio (P/S) comes in quite handy when evaluating unprofitable companies, which do not have a P/E ratio. Like the other price multiples, the P/S ratio can also be used to compare firms within an industry. For value investors, a P/S ratio lower than 1.0 often indicates an opportunity, but it's critical to properly account for sales, debt, different costs, and profit margins across firms. The ideal situation for us would be a company with a low P/S multiple and a relatively high profit margin.

P/S Ratio = Market cap (shares outstanding x market price per share)/Total sales

Total sales can be found at the top of the income statement. Some companies will list total sales (also called revenues) on the first line, while others will list revenues from different business segments first and then add them to get total sales. Some companies will use "net sales" instead of total sales, which is arrived at by subtracting cash discounts, goods returned for credit, and other allowances. It is fine to use net sales in calculating the P/S ratio.

The ABCs of P/S
1. Unlike the P/E and P/B ratios, the P/S ratio doesn't involve accounting estimates that can be used by the company to inflate, or even deflate, earnings. That said, companies can still manipulate sales, so we must look carefully at how a company records its revenues.

2. For cyclical companies and turnarounds, we cannot use the P/E ratio when earnings are negative. But as long as the company is not headed for bankruptcy, we can use the P/S ratio to track what the market is willing to pay for its sales. If the company's P/S ratio is much lower than others in its industry, it may indicate a value opportunity. For young companies yet to make a profit, we often look for high sales growth, which we hope will translate into net earnings and, ultimately, free cash flow. The P/S ratio tells us how much the market is paying for sales and gives some indication of value.

3. Some investors consider a relatively low P/S ratio with a rising stock price (high relative strength) to be a good basis to invest in growth stocks that have suffered a temporary setback.

4. As with P/E and P/B, the P/S ratio can help compare a stable company's current value to its past valuations. Websites such as MSN Money will display the price ratios for the past 10 years. If the current P/S ratio is less than the 10-year average, it may indicate a value.

P/S under the microscope
1. Just as the P/E ratio should be considered with earnings growth and the P/B ratio with return on equity, the P/S ratio should be considered in tandem with net margin (also called net profit margin, it's net income divided by total sales). Wal-Mart (NYSE:WMT) and Microsoft (NASDAQ:MSFT) (both Motley Fool Inside Value picks) are fine companies with very strong competitive advantages, but a comparison of their P/S ratios alone tells us very little. Wal-Mart has a P/S ratio of 0.55, compared to Microsoft's 5.85. Earlier, I said that a P/S ratio under 1.0 generally has been used as a value benchmark, which would suggest that Wal-Mart is undervalued and Microsoft is considerably overvalued. Yet a check on their net margins explains this discrepancy: Microsoft's net margin is 28.45%, and Wal-Mart's is just 3.23%. Microsoft's greater profitability is reflected in its price, which accounts for its higher P/S ratio.

2. A company can book sales for which it has not yet provided the goods or services, or before a customer is obligated to pay. This is called channel stuffing; it leads to inflated sales and earnings, and consequently, lower P/S and P/E ratios. In August 2004, the Securities and Exchange Commission settled a case against Bristol-Myers Squibb (NYSE:BMY) for improperly recognizing revenues and channel stuffing. To make sure this is not happening, look at the receivables on the balance sheet. If they are increasing a lot faster than sales, it is likely that some revenues are not being collected. Another warning would be declining cash flows from operations on the cash flow statement, even as net earnings rise.

3. Generally a company with higher debt will have a lower P/S ratio, because some of those sales, when converted to cash, have to go toward debt interest and paying down debt -- not to equity holders. When comparing companies with significantly different debt loads, it's best to compare enterprise value-to-sales (enterprise value = market capitalization + debt - cash). For an example, look at theme-park operator Six Flags (NYSE:SIX), which has a P/S ratio that seems to be in value territory at 0.44. However, Six Flags is carrying $2.13 billion in long-term debt and just $83 million in cash. Its market cap is $466 million, but its enterprise value is $2.77 billion. The EV/S ratio is 2.51, which does not indicate a value for a company that is not currently making a profit, and one that is not expected to do so next year either.

4. A company that earns commissions on total sales may book total sales on its income statement instead of commissions, thereby drastically lowering the P/S ratio. This is perfectly legitimate, but it distorts the P/S ratio. Consider online travel company (NASDAQ:PCLN). Its total trailing-12-months revenue is recorded on the income statement as $1.01 billion, but the revenue flowing to the company is recorded as $323 million, with the difference reported as cost of goods sold. The current P/S ratio is shown on all financial websites as 1.29, generally indicating a pretty good value, but based on the actual commissions received by the company, the P/S ratio would be 4.03.

P/S postscript
That's just a brief look at the P/S ratio, and I've only touched on a few of the wrinkles associated with it. As a measure of value, P/S is particularly useful for a young growing company, or a company without any earnings, but as with other valuation metrics, it should not be used in isolation.

This article was originally published on Nov. 15, 2005. It has been updated.

Philip Durell heads up the Fool's Inside Value newsletter service. To date, his picks are outperforming the S&P 500. If you'd like to join Philip on the search for undervalued stock opportunities, you can sample his service for 30 days for free.

Philip owns shares of Microsoft. The Motley Fool has a disclosure policy .

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