Before you start investing in a company, it is vital to study its chart and financial reports. However, most often this is not enough, and you might need to use multipliers. This article is devoted to one of them: it describes the principle of its work and how it can help investors in the stock market. This multiplier is P/S.
What is the P/S multiplier?
P/S is a multiplier that demonstrates the Price/Sales ratio. In other words, it assesses sales volumes of the company and shows how much investors pay per dollar of profit. It is a type of an indicator that calculates the ratio of the company's revenue and other characteristics. The formula is as follows:
P/S = Market Price of the company / Sales Volume
The market price of a company is the cost of the shares it has in the market, normal and privilege stocks together.
Sales volume is the money they get upon selling a product or service.
Advantages and drawbacks of P/S
- Calculation does not require special knowledge;
- The net profit of the company might be revised or be negative, while revenue will be positive almost all the time. This simplifies evaluation of the company by this parameter;
- The stock price and revenue dynamics allows evaluating the stage of the company's development (if the value is zero, the company is stagnating) ;
- Net profit can often be used for manipulating investors but with revenue, this seldom works;
- The company's revenue does not often depend on the company's fiscal policy and demonstrates its opportunities and perspectives.
- P/S cannot be used for companies that do not trade any products in the plain sense (such as insurance companies and banks);
- A company might have a large revenue and a small profit, which, in turn, makes P/S faulty;
- Having a high revenue for several quarters in a row, the company can spend everything on development or paying dividends. As a result, investors will have a negative attitude in the next quarter, and the stock price drops.
- Creditors get access to the information, so that they may require payments and thus influence the P/S multiplier.
Example calculation of P/S
Let us see on examples how P/S is calculated.
The ABC company issued 1 million normal and 1 million privilege shares. The price is 2 USD per stock, and the revenue in the reporting period amounted to 5 million USD. Divide market capitalization per revenue:
2 million shares * 2 USD = 4 million USD
P/S = 4,000,000/5, 000,000 = 0.8 USD
Hence, an investor pays 0.8 USD per each dollar of profit. Now - how can we use this in practice?
Normal P/S values
- A P/S value between 1 and 2 means that the market gives a balanced evaluation of the company and has no reasons for the profit to drop.
- A P/S value above 2 means that the shares are overvalued, so there are no reasons for further active growth. You should probably keep an eye on this company because after the stock price drops, it might be appealing for buying.
- A P/S value under 1 means that the company is undervalued and has a good potential for growth.
Patterns of P/S
- When sales volume increases, the multiplier value shrinks.
- When the stock price (capitalization) grows, P/S value also grows.
In our example calculation, the P/S value of ABC is 0.8, which means the shares are undervalued, and the price might grow soon. Such shares are promising investment options. A decrease in the P/S value means revenue is growing compared to capitalization. This might mean the following:
- Investors lose confidence and optimism when revenue turns into net profit;
- The shares are undervalued.
The growth of P/S might mean that:
- Capitalization is growing (the stock price is increasing) ;
- Revenue is shrinking (if the stock price is more or less stable).
P/S is less volatile than other indicators and reflects the state of the company's affairs more precisely.
How to use P/S?
These days there is no need calculating P/S manually as you can find the values in popular screeners. In a screener on any popular resource choose the required parameter of the multiplier and get a list of suitable companies.
There are several ways of using the indicator. First hand, try to evaluate the company by several reporting periods, at least for a couple previous years.
Assessing companies from non-related sectors of economy is irrelevant. The multiplier works only with rivals applying the same principles of work. A high revenue and small profit does not mean that the company is doing bad. Quite often, companies merge with rivals and spend some money pn development and updates. This worsens P/S results but not the performance of the company.
One must not assess a company by just P/S, this is un objective. As most other multipliers, P/S is used alongside other multipliers and financial reports. The main function of P/S is helping you find undervalued companies and promising investment options.
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