We display a price-to-sales or p/s ratio with every stock we cover in our newsletters, including our flagship publication, The Successful Investor.

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

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 financial 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 financial ratios in perspective. They tend to provide hints rather than clear answers.

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.

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On the other hand, suppose a company has 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.

Companies in the same industry tend to have similar price-to-sales ratios

P/s financial ratios tend to be similar among companies in the same industry. Two stocks in the telecommunications industry provide examples: BCE Inc.’s (symbol BCE on Toronto) price-to-sales ratio is 1.3, and Telus Corp.’s (symbols T and T.A on Toronto) is also 1.3. We cover both stocks in The Successful Investor.

P/s financial ratios can also differ between companies within an industry because of factors peculiar to the company’s business concept, location, product line or whatever.

However, these two firms have similar cost structures and product lines, and operate under more or less the same industry conditions.

Don’t rule out a company solely because of its p/s ratio

In the latest issue of The Successful Investor, we take a close look at Gennum Corp. (symbol GND on Toronto). Gennum makes equipment that stores, manipulates and transfers video signals. It also makes chips that improve the flow of data inside networks.

Gennum’s price-to-sales ratio is a high 2.6. The company needs growth and higher profit margins to justify that price-to-sales ratio. But its small size (sales in the latest quarter were $29.5 million) means it can record substantial growth by adding just a few million dollars to its sales. As well, Gennum spent $8.3 million (or a high 28.2% of its sales) on research in the latest quarter. The products that result from this spending could also spur the company’s growth.

We take a close look to see whether these factors are powerful enough to justify the company’s price-to-sales ratio in the latest Successful Investor. What’s more, you can get this issue absolutely free. Click here to learn how.