What is PSR?
Before we discuss what the Price/Sales Ratio is, or as it is commonly referred to as the PSR, we first have to define what the word revenue means. It is “the entire amount of income before any deductions are made” (http://www.wordreference.com/definition/revenue).
So if Company X has 100 million shares of, say, 20 USD, and the last twelve months’ total sales were 20 billion USD, and has 0 USD current long term debt, then Company X’s PSR would be:
(100 million* 20+0)/20 billion=2 billion/20 billion=0.1
The PSR takes the current market capitalization and divides it by the total sales of the last 12 months.
we can see that the Price/Sale ratio (or Price/Sales Multiple) is 0.1.
As the correct value of any company is 1.0 according to PSR, the above
company would currently be valued to a tenth of its correct price. This
means that analists and brokers would recomend it to a "strong buy".
Uses of PSR
The PSR is most often used when companies consider and make acquisitions, and is a very valuable method in measuring the overall current value of the company.
As was the case with the PEG and the YPEG ratios, the lower the PSR is, the better. This is so, because in the case of a low PSR each dollar invested would generate quite high levels of sales. If the Price/Sales ratio were high, that would mean that each dollar invested in the company would generate low sales revenues, and generally could be said that the company is overvalued. As a rule of thumb, companies with a PSR below 1.0 are recommended for a purchase.
Another advantage of the PSR is that it can be compared to other companies’ of the same industry, even if the company made losses. For instance, if Company X has a PSR of 0.5, whereas the industry average is 2.0, we can assume that Company X, if it increases its sales, its PSR will also converge to the 2.0 industry average. Even if its sales revenues remain constant, by decreasing costs, the market, assuming that it is an efficient market, will start to value the stocks higher, thus increasing the market capitalisation of Company X.
In times of recessions, when the whole of the industry, for instance the automobile manufacturing companies, are loosing money, it is advisable to rather use the PSR instead of the P/E ratio.
Investors often use the P/E ratio and the PSR as complements of each other. If the company has a low P/E, but a high PSR, it could imply that the company probably had an exceptional, one-time gain, increasing the earnings of the company. This is so, because the non-recurring sale boosts the earnings of the company, making the ratio of the P/E exceptionally low.
Companies operating in high growth industries are usually priced based
on the usage of multiples of revenues instead of multiples of earnings, because
in such industries companies tend to focus on the growth of their sales and not
on their profitability and efficiency, in order to be able to maintain or
increase their market shares. An excellent example of such a company would be Amazon.com in the 1990s.
Sometimes, to better suit the comparability of shares of stocks, on mid-, and longer terms, annalists sometimes use a five year PSR average. This five-year-PSR is calculated by simply dividing the average PSR for the period, using 5 in the denominator. (Dow Theory Forecasts 2004, p.1)
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