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, including how to use financial ratios and other information in your stock research. 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: “Use the price-to-sales ratio correctly and you can uncover stocks with strong growth potential.”

We display a price-to-sales or p/s ratio with every stock we cover in our Wall Street Stock Forecaster newsletter. It lets you see how the stock is doing relative to the company’s sales.

You get the price-to-sales ratio when you divide a stock’s price by its sales per share (you arrive at sales per share by dividing total annual sales by the number of outstanding shares).

Financial ratios like price-to-sales are just one way to measure a stock

The basic rule is that a lower price-to-sales ratio means that a stock is cheap. A higher p/s tends to indicate that a stock is expensive. Still, 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. They tend to provide hints rather than clear answers. They are only one among many tools in your stock research.

Price-to-sales ratios can signal 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 — 20, say —its price-to-earnings (or p/e) ratio has to exceed 20, since “e” is always less than “s”. In that case, its rate of sales growth will have to be very high if it is ever to earn enough profit to justify its current stock price, let alone go higher.

On the other hand, you might uncover 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, a low p/s is an advantage only if a company can make money on its sales. If the company can’t make a profit, its low p/s may signal danger, rather than a bargain. The low p/s may reflect the fact that well-informed investors are selling the stock (and driving down the ‘p’). Money-losing companies eventually go out of business.

Using financial ratios to your best advantage in the search for fast-growing stocks

In the latest issue of Wall Street Stock Forecaster, we looked at Apple Inc. (symbol AAPL on Nasdaq). The computer giant continues to pump up its earnings thanks mainly to strong sales of its iPhone smartphones and iPad tablet computers.

Apple’s price-to-sales ratio is somewhat on the high side, at just over 4, yet that’s reasonable for a fast-growing tech stock. What’s more, the stock is trading at just 14 times its likely earnings for 2012. That’s pretty low considering the company’s brisk growth.

The two ratios give you a picture of a stock that is still growing rapidly. It’s smart to use more than just one financial ratio, so that you’re not getting only part of the story.

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