This is the 4th part in my series on stock valuation methods. I've previously covered the Graham Number, Average Dividend Yield and Average P/E Ratio. Today I'm going to take a closer look at the average low P/S ratio method. This one is pretty much the same as the dividend yield and price-to-earnings ratio methods except now we focus on the revenue side of the business.
Sales are the number one thing a company is after. You can't make a profit if you don't bring in any revenue and you can only increase your profit margin to a certain extent before you have to increase revenues to grow your business. I like to look at the price in relation to the revenue or sales per share that a company can generate.
Like almost any other metric this is very specific to each industry. I wouldn't be willing to pay as much on a P/S basis for say Apple as I would for Proctor & Gamble. Why you might ask? Well that's because the revenue for PG is much more stable, reliable and predictable than the revenue for Apple. Apple's products could no longer be sought after by consumers in the next month, whereas we all need toilet paper, laundry detergent, razors, toothpaste and the rest of the PG product line in our every day lives.
In order to calculate the P/S ratio you simply look on the income statement of the most recent annual report or the last 4 quarterly reports for whichever company you're interested in. The total revenue will be listed at the top of the income statement. Now that we have the total revenues we need to convert to a per share basis by dividing it by the shares outstanding. You can find the shares outstanding near the bottom of the income statement as well. As I've mentioned before, I prefer to use the fully diluted shares outstanding since that accounts for all potential shares due to options, convertible bonds, etc.
The rest is easy. Just take the high and low prices for each fiscal year and divide that by the revenue per share value for the corresponding fiscal year. From here it's just a matter of taking the average of the last 5 or 10 years to come up with the historical trend. Then I compare the analyst estimates for revenue to the current price to see whether it's currently under, fairly, or over valued.
As I've mentioned in every single post on my stock valuation series, each valuation method should not be taken as gospel. They each have their strengths and weaknesses and should not be taken as the be all end all to determine a entry price for a company. The market is very fickle and companies go through different growth phases at different times in the economic cycle. Some companies barely even register a recession because they are consumer staple companies that provide products we all use every day. Others such as industrial companies will have wild swings in the revenue and profitability because they are so closely tied to how well the economy as a whole is doing. This is why I prefer to use multiple valuation techniques to be able to determine a valuation range and compare across the different methods.