We all want to find solid companies, and we want to buy them at attractive prices. But that's easier said than done -- some of the best methods of estimating a company's true value are rather complicated. That's why many people love the simplicity of the price-to-earnings (P/E) ratio, or its cousin, the price-to-sales (P/S) ratio. The latter is especially handy when a company has no earnings.
In general, the lower the P/S, the better. Here are some large-caps with low P/S ratios, along with a couple of companies with higher ones:
|
Company |
Price-to-Sales Ratio |
|---|---|
|
UnitedHealth |
0.36 |
|
Arcelor Mittal |
0.38 |
|
Target |
0.44 |
|
General Electric |
0.68 |
|
ExxonMobil |
0.78 |
|
EnCana |
1.20 |
|
McDonald's |
2.75 |
Data: Yahoo! Finance.
Judging from this list, you might think that Target is a much more attractive stock than McDonald's. You might also think that General Electric looks better than EnCana. But you'd be drawing hasty conclusions. It can be very tempting to look at just one or two measures of a stock, but doing so won't serve your portfolio well.
Price-to-sales caveats
For example, notice how the P/S ratio depends on sales, also referred to as revenue. To get the full picture, you need to look into exactly where a company gets its revenue. You'd rather see it coming from its ongoing, regular business operations than from extraordinary one-time events that aren't likely to repeat themselves.
In addition, sales aren't the only important measure of success. Many companies take in a lot of revenue, but keep very little of it as profit. And if a company has a lot of debt, it'll be less attractive than less-burdened counterparts, even if it has a low P/S ratio. Let's look at the companies above with a few more numbers:
|
Company |
CAPS Rating (Out of 5) |
Net Profit Margin |
Debt-to-Equity Ratio |
|---|---|---|---|
|
UnitedHealth |
***** |
3.6% |
0.55 |
|
Arcelor Mittal |
***** |
5.4% |
0.59 |
|
Target |
*** |
3.3% |
1.33 |
|
General Electric |
**** |
8.9% |
4.99 |
|
ExxonMobil |
**** |
9.5% |
0.09 |
|
EnCana |
***** |
23.3% |
0.40 |
|
McDonald's |
**** |
18.9% |
0.82 |
Data: Motley Fool CAPS, Yahoo! Finance.
See how that fills in the blanks? Arcelor Mittal has similar P/S and debt ratios, but a much steeper profit margin than UnitedHealth. EnCana has a higher P/S, but its profit margin is huge and its debt low.
Make sure you understand the role price-to-sales ratios play in finding stock bargains. The P/S is a helpful measure to know, but it's just one of many important considerations to take into account when picking a stock.
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