Price-to-sales is one of the key financial ratios we look at when we assess a company. That’s the ratio you get when you compare a stock’s price to its sales per share (you get sales per share by dividing total annual sales by the number of shares outstanding).

Price-to-sales, or p/s, is one of the financial ratios you’ll find displayed with every stock we cover in our Successful Investor newsletter.

The basic rule is that a high p/s tends to mean that a stock is expensive, and a low p/s tends to mean that a stock is cheap. However, many individual stocks seem to run counter to this rule. Stocks with deservedly high p/s ratios can rise for lengthy periods, and stocks with deservedly low p/s ratios can fall.

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Avoid relying too much on financial ratios like price-to-sales

The price-to-sales or p/s ratio is one of the more useful financial ratios, although it is not precise. Sales is the raw material of profit; that is, sales minus expenses equals earnings, so profit is always less than earnings.

So, if a stock has a high p/s ratio — 30-to-1, say — then its price-to-earnings (or p/e) ratio has to exceed 30-to-1, since “e” has to be less than “s”. In that case, it needs very high sales growth rates if it is ever to earn enough profit to justify its current stock price, let alone go higher.

On the other hand, suppose a company has a very low price-to-sales ratio, such as 1-to-100 (for example, a $1 stock with $100 a share in sales). That can indicate a lot of capital-gains potential, if the company can improve its profit margin.

However, if a company can’t make money, a low p/s is no advantage. In fact, it usually signals danger, rather than a bargain. Money-losing companies eventually go out of business.

A company’s price-to-sales ratio can set it apart from its peers

P/s ratios tend to be similar among companies in the same industry. But these financial ratios can also differ widely between companies within an industry because of factors peculiar to the company’s business concept, location, product line or whatever.

For example, a company can have a higher or lower p/s ratio because it has a higher or lower cost structure, a product line that stresses products with higher or lower profit margins, or other characteristics that give it an advantage or disadvantage in relation to others in its field.

Like all financial ratios and tools, the p/s ratio is worth looking at, but only if you put it in perspective. It gives hints rather than definite answers.

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