Lesson 4 of 6
Reading a price to sales ratio
A price to sales ratio has no good level on its own because it says nothing about whether the sales make money. A margin turns it into a P/E.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A price to sales ratio contains no information about whether the sales make any profit.
- Divide it by the net margin and it becomes the price to earnings ratio that margin implies.
- Two competitors with identical economics can show sales multiples of 0.5x and 5.0x for one accounting reason alone.
A price to sales ratio of 3 is not high or low. A dollar of software revenue and a dollar of grocery revenue are priced differently for reasons entirely correct, and the ratio on its own cannot see any of them.
One sales multiple, three margins
- 10% net margin, implied P/E 30x30x
- 20% net margin, implied P/E 15x15x
- 30% net margin, implied P/E 10x10x
Making it readable
Implied P/E equals Price to sales divided by Net margin.
Example3.0x ÷ 20% = 15x
The same multiple of sales is three different prices depending on what the sales earn. That is why a sales multiple only compares companies with similar cost structures, and why carrying one across industries is arithmetic with a term missing.
What a high multiple is really asserting
At today's margin the price is 160 times earnings. The multiple is asserting that revenue triples and the margin triples with it. Both may happen; the point is that the price already contains both assumptions, so the honest question is whether that pair is likely, not whether the multiple looks high.
Gross or net can move it tenfold
One business, reported gross and net
Reported gross, as principal
- Revenue of 1,000, net income of 20.
- Price to sales of 0.5x on a 500 market cap.
Reported net, as agent
- Revenue of 100, net income of 20.
- Price to sales of 5.0x on the same 500 market cap.
Same economics, same profit, same price. The sales multiple moves by a factor of ten.
A rule named ASC 606 (Accounting Standards Codification Topic 606, Revenue from Contracts with Customers.) decides whether a company reports gross as principal or net as agent, turning on whether it controls the good or service before it reaches the customer. Two competitors can show sales multiples of 0.5x and 5.0x, both at 25.0x earnings, on identical economics.
Where it earns its place
On a company with no earnings yet, where nothing else can go in the denominator. On a cyclical company at the bottom, where earnings near zero make the P/E meaningless. And as a stability check: revenue sits above depreciation, impairments and tax, so volatile earnings against steady revenue points at costs, not demand.
Do it on a real 10-K
- Open the revenue recognition note in Item 8 and find the principal-versus-agent conclusion the company is required to state.
- Find the disaggregation of revenue in the same note and check how much of the total is a pass-through the company never keeps.
- Take the highest net margin the company has filed in its history and compute the price to earnings ratio that margin implies.
Check yourself
Why can a price to sales ratio of 3 not be called high or low on its own?
- Because sales figures are unreliable
- Because it says nothing about whether the sales produce any profit
- Because sales are always growing
Show the answer
Answer: B.
The ratio has no margin in it. The same multiple of sales can be cheap or expensive earnings depending on what the sales earn.A price to sales ratio of 3.0x sits against a 15 percent net margin. What price to earnings ratio does that imply?
- 3x
- 15x
- 20x
Show the answer
Answer: C.
3.0 divided by 0.15 is 20. Dividing the sales multiple by the margin turns it into the earnings multiple it stands for.Two identical competitors report revenue differently under ASC 606. What can happen to their price to sales ratios?
- Nothing, ASC 606 does not affect revenue
- They can differ by a factor of ten with identical profit
- They must be identical if profit is identical
Show the answer
Answer: B.
Reporting gross as principal or net as agent changes reported revenue by an order of magnitude with no change to profit at all.Sources
- ASC 606, Revenue from Contracts with Customers.
- Damodaran, The Dark Side of Valuation, on valuing companies with no earnings history by forecasting the path to a mature margin.
What this leaves out
- No level of price to sales is named as attractive. The implied-earnings arithmetic states an assumption; it does not test one.
- Revenue involves judgements too, principal against agent among them; read the revenue note before trusting the denominator.
- The worked examples use round invented numbers so the arithmetic can be checked.
- Nothing here is advice about any security.