A famous quote says, “The stock market is filled with individuals who know the price of everything, but the value of nothing.”
When it comes to evaluating stocks for investment, one of the most commonly used and popular ratios among investors is the Market Capitalization to Sales (P/S) ratio. This ratio provides valuable insights into how the market values a company in relation to its sales revenue.
Market capitalization to sales (market cap to sales or P/S ratio) is a financial ratio that measures the value of a company relative to its sales. It is calculated by dividing a company’s market capitalisation by its sales.
Market capitalisation is the total value of a company’s outstanding shares, and it is calculated by multiplying the company’s share price by the number of outstanding shares. Sales are the revenue that a company generates from its business activities.
Market Capitalization to Sales (P/S) Ratio Formula:
P/S ratio = Market Capitalization ÷ Sales
Example of Market Capitalization to Sales
Let’s say that a company has a market capitalization of Rs 100 crore and sales of Rs 50 crore. The company’s P/S ratio would be calculated as follows:
P/S Ratio = Rs 100 crore / Rs 50 crore = 2
This means that the company’s stock is trading at a valuation of 2 times its sales.
Interpreting the P/S Ratio
Low P/S Ratio (Below 1): Indicates that the company’s stock may be undervalued relative to its sales. This could signal an attractive investment opportunity.
Moderate P/S Ratio (Around 1): Suggests that investors are willing to pay roughly the same amount as the company’s annual sales to own its stock. It’s considered a fair valuation, though industry and circumstances matter.
High P/S Ratio (Above 1): Suggests investors are willing to pay more for each dollar of the company’s sales. This could imply an overvalued stock, so caution is advised.
How to use market capitalisation to sales
The P/S ratio can be used to compare the valuation of different companies within the same industry. It can also be used to track the valuation of a company over time.
For example, if an investor is interested in investing in the technology sector, they could compare the P/S ratios of different technology companies to see which ones are trading at a more attractive valuation.
An investor could also track the P/S ratio of a company over time to see if it is becoming more or less expensive relative to its sales. If the P/S ratio is decreasing, it means that the company is becoming less expensive relative to its sales. This could be a sign that the company is undervalued and could be a good investment opportunity.
The P/S ratio is a useful valuation ratio, but it is important to be aware of its limitations.
One limitation is that the P/S ratio does not take into account the profitability of a company. For example, a company with high sales but low margins may be less valuable than a company with lower sales but higher margins.
Another limitation is that the P/S ratio can be manipulated by companies. For example, a company can increase its sales by lowering its prices or by offering discounts. This is why it is important to consider other factors, such as a company’s profitability and debt levels when using the P/S ratio to value a company.