Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.
Today’s tip: “How your stock research can benefit from price-to-sales ratios.”
We display a price-to-sales or p/s ratio with every stock we cover in our newsletters, including Wall Street Stock Forecaster, our newsletter for investing in U.S. stocks.
Price-to-sales is 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 outstanding shares).
Treat financial ratios like price-to-sales as one tool among many in your stock research
The basic stock research 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.
That’s why it’s important to keep price-to-sales ratios in perspective in your stock research. They tend to provide hints rather than clear answers.
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How price-to-sales ratios can signal the potential for future gains
Sales is the raw material of earnings; that is, sales minus expenses equals earnings, so earnings are always less than sales.
So, if a stock has a very high p/s ratio — 30, say —its price-to-earnings (or p/e) ratio has to exceed 30, 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 your stock research uncovers a company with an extraordinarily low price-to-sales ratio, such as .01 (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 then 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.
Stock research: Don’t rule out a company solely because of its p/s ratio
In the latest issue of Wall Street Stock Forecaster, we take a close look at Adobe Systems Inc. (symbol ADBE on Nasdaq). The company makes software that lets computer users create documents in the popular PDF format. It also makes software that lets graphic designers create print publications and web pages.
Adobe’s price-to-sales ratio is a high 4.2. The company needs growth and higher profit margins to justify that price-to-sales ratio. However, Adobe continues to see strong demand for its Creative Suite 5 package of photo-editing and desktop-publishing programs. Sales of its Acrobat 10 PDF software have also been rising.
We take a close look to see whether these strengths are powerful enough to justify the company’s price-to-sales ratio in the latest Wall Street Stock Forecaster.
Best of all, right now you can get this issue absolutely FREE. In addition to our full analysis of Adobe (including our clear buy/sell/hold advice on the stock), the latest issue contains our special analysis of 6 U.S. stocks you need to sell now. If you’re holding these companies, we strongly recommend that you sell them right away—to avoid the potential for big losses.
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