What Is Considered A Good Price-To-Sales Ratio?

The price-to-sales (P/S) ratio is an important valuation metric that compares a company’s market capitalization to its total revenue over the past 12 months. This ratio gives investors an idea of how much they are paying for each dollar of sales generated by the company. A lower P/S ratio is generally considered better, as it suggests the stock may be undervalued. But what exactly is considered a “good” P/S ratio?

As with any financial ratio, there is no one-size-fits-all answer. The appropriate P/S ratio varies significantly across different industries. A high-growth tech company will often have a much higher P/S ratio than a mature industrial manufacturer. The average P/S ratio within each sector provides a useful benchmark for comparison.

According to NYU professor Aswath Damodaran, the current average P/S ratios across sectors are

• Tech: 5.5x
• Healthcare: 4.4x
• Consumerservices: 2.4x
• Consumer goods: 2.2x
• Industrials: 1.6x
• Basic materials: 1.0x
• Utilities: 1.6x

So clearly, a P/S ratio of 5 would be stellar for an industrial company but worrisomely low for a tech company. The key is to compare companies to their direct competitors within the industry.

While industry averages provide a helpful starting point, other factors also impact what P/S ratio is attractive for a given company Here are some considerations

Growth Outlook

High-growth companies warrant higher P/S ratios, because investors are betting on future earnings potential. Young companies pursuing an aggressive growth strategy would be expected to have above-average P/S ratios. Mature companies with steady, predictable growth command lower ratios.

Profit Margins

The P/S ratio only considers revenue and ignores profitability. But a company with fat profit margins will trade at a higher multiple than a company with razor-thin margins, all else being equal Investors will pay more for $1 of sales if that $1 is highly likely to convert into profits.

Capital Structure

The P/S ratio does not account for debt levels. So a company with significant leverage may have a lower P/S ratio than a comparable unlevered peer. The EV/Sales ratio improves upon P/S by incorporating debt and cash into the valuation.

Quality of Revenue

Recurring revenue streams from long-term contracts are valued more highly than one-time transactional revenue. Software-as-a-service (SaaS) companies, for example, command premium P/S ratios due to their subscription-based business models.

Competitive Advantage

Companies with wide economic moats, strong pricing power, and customer loyalty can extract more value from each dollar of sales. The strength and sustainability of a company’s competitive edge factors into its deserved P/S multiple.

Now let’s walk through some examples to get a feel for good P/S ratios:

• Company A trades at a P/S ratio of 0.8x, while its direct competitor trades at 1.2x. All else equal, Company A appears undervalued and attractive for investment.

• Company B has posted 20%+ revenue growth annually for the past 5 years. Its P/S ratio of 4x, while above industry average, seems justified by the impressive growth.

• Company C operates on razor-thin 2% net margins, while competitors average 8%. Its below-average P/S ratio of 1.5x makes sense given the weak profitability.

• Company D relies heavily on leverage, with a debt/equity ratio of 2.0x. Its P/S ratio of 1.2x likely understates the valuation relative to its all-equity competitors trading at 2.0x sales.

• Company E enjoys strong pricing power and over 80% recurring revenue. A premium P/S ratio of 3.5x (vs. 2.5x industry average) looks attractive for this high-quality revenue stream.

The bottom line is that the appropriate P/S ratio depends heavily on the company specifics. While a lower ratio is broadly better, high growth potential, strong competitive advantages, and recurring revenue streams may justify higher multiples. The key is not to focus on P/S in isolation, but to consider it as part of a holistic evaluation of a company’s fundamentals and future prospects.

When assessing any potential investment, prudent investors will gather a variety of perspectives. Check the company’s historical P/S range, compare to industry peers, evaluate future outlook, and analyze other financial ratios before passing judgement on the stock as undervalued or overvalued. No single ratio provides the full picture.

The P/S ratio has some limitations worth noting. Firstly, it can be misleading when comparing companies across vastly different industries, since each sector has its own normal range. Secondly, it ignores profit margins, so fails to measure how efficiently sales drive bottom-line profits. And thirdly, it does not account for balance sheet risk, since no leverage or liquidity ratios factor in.

Despite these shortcomings, the P/S ratio remains a quick and useful first-pass metric to include in your toolkit when screening for potentially underpriced stocks. Combined with other ratios like P/E and P/B as well as due diligence on the qualitative aspects of the business, the P/S ratio can help identify good investment opportunities trading below their fair value.

So while there are industry-specific guidelines, the real answer to what’s a “good” P/S ratio depends on the company’s individual growth outlook, competitive position, balance sheet, and future prospects. Use the P/S ratio as one helpful input, not the sole deciding factor, when constructing your investment thesis. A stellar business with improving margins and defensible competitive advantages may deserve a seemingly high P/S ratio. Likewise, a struggling business in secular decline may warrant a P/S well below its industry peers. As with most investing questions, “it depends” is the truth!