Another ratio, which we have found to be a useful tool, is the Price/Sales (P/S) ratio. It is calculated as a stock's current market price divided by its sales (revenue) per share. Again when calculating this ratio, we use the company's revenue from its latest four quarters or on a trailing basis.
We find that because sales is a more strictly defined figure than earnings, the P/S ratio tends to give more reliable insight into a company than the P/E ratio. There are countless ways in which management may inflate or suppress earnings, yet it is much more difficult, and, in fact, borders on fraud, to artificially create or destroy revenues.
Although the average P/S is higher in some industries than others, the acknowledged "rule of thumb" is that a stock with P/S ratio below 0.75 can be considered under-valued. It is also generally accepted that an investor should avoid most companies with a P/S ratio above 3.0.
Although we believe the P/S ratio can be a valuable addition to your toolbox, we suggest you interpret it cautiously in certain situations:
Companies on the verge of bankruptcy, often emerge with very low P/S ratios. This can be due to the fact that, initially their sales may experience only a slight drop-off, while their share prices plummet.
The ratio ignores a company's capital structure. In other words, a highly leveraged or high debt-load company can show a low P/S ratio, yet remain unprofitable because of its inability to cover its interest obligations with operating income.
Average P/S ratios can vary significantly from industry to industry. For example, companies in the computer software industry tend to show higher average P/S ratios, yet this does not necessarily mean they are not good buys. This is because the industry companies typically exhibit high margins, or are able to convert a great deal of their sales dollars into profits.
Try calculating the P/S ratios for all stocks in your portfolio. If all of your companies are trading at or more than twice their sales per share, a ratio of 2 or above, it is a good indication you are carrying excess risk.