Clearly, you need to know whether a stock has any room to grow before you make an investment decision. If the stock is modestly priced relative to its industry peers and you believe it has solid growth prospects, then you have an investment candidate.
On the other hand, a wildly over-priced stock usually has only one way to go. It may still be an investment candidate, but only when the price is more attractive.
The Right PriceThe price/sales ratio is one of the tools that will help you determine which category a stock is in and help you make an informed investment decision.
Stock prices tell you nothing. IBM was selling for $93.22 and Dell was quoted at $41.42. Which is the better buy? If you knew nothing about the companies, the stock prices give you no hint. Is IBM a better company because its stock is more expensive or is Dell a bargain?
The price/sales ratio creates a metric that allows you to compare companies in the same industries. You calculate it by dividing the market capitalization of the company by its revenue.
Market capitalization or market cap is simply the number of shares outstanding multiplied by the per share price. For example, a company with 100 million shares outstanding and a per share price of $55 would have a market cap of $5.5 billion. See Size Matters in Investing.
By dividing the market cap by revenues, you get a number that you can use to compare companies in the same industry. The lower the number, the better. It is important that you only use the price/sales ratio to compare companies in the same industry since there will be differences among industry groups.
Price/sales Ratio RevealsLets take another look at Dell and IBM. Based on the quotes above, IBMs price/sales ratio was 1.7, while Dells number was 2.2. For the industry group, the price/sales ratio was 2.8.
Both stocks were selling under the industry average, however looking at just the price/sales ratio IBM was the better value at 1.7.
One of the ways you can use price/sales ratio numbers is to check the other prime value metric, the price earnings ratio. See Price Earnings Ratio.
Continuing our example, IBMs P/E was 20.1 and Dells was 34.3. The industry group P/E was 33. According to the P/E, it appears that IBM is still the better value.
If the price/sales ratio and the price/earning ratio contradict each other, that is a sign that something is up with the companys books. Look for a one-time event that may have distorted the financials on a temporary basis.
Where to FindYou can find both the price/sales ratio and the price/earnings ratio along with other metrics on many sites. One that I use extensively is Morningstar.com.
Enter a stock symbol and you are taken to a detailed quote/background screen on the stock. From there you can gather all the information I used in this article and much more.