What it means
The ratio is calculated as market capitalisation divided by annual revenue, or equivalently share price divided by revenue per share. Because revenue is far harder to manipulate than profit, the measure gives a comparatively stable view when earnings are volatile or negative.
That stability is exactly why it is popular for young, fast growing companies. A business investing heavily in growth may report losses for years while its sales triple, and a price to earnings ratio is simply unusable in that situation.
The obvious weakness is that revenue says nothing about whether the business can convert sales into cash. A grocery chain and a software company can report identical revenue while one keeps 2 cents of every dollar and the other keeps 25 cents, so their price to sales ratios should never be compared directly.
The sensible way to use it is within a single industry, alongside the margin the business actually earns. A company on a price to sales ratio of 1.5 with a 20% operating margin is usually better value than one on 1.2 with a 4% margin.
One refinement worth knowing is the enterprise value to sales ratio, which adds debt and subtracts cash before dividing by revenue. That version compares the whole business rather than just the equity slice, so it is fairer when the companies being compared carry very different amounts of borrowing.
In practice
Real-world examples.
Example
A loss making online marketplace cannot be valued on earnings, so its bankers price the flotation using a price to sales ratio of 4.0 based on comparable listed marketplaces. Revenue of $150,000,000 therefore implies a market value near $600,000,000.
Example
A supermarket group trades on a price to sales ratio of 0.3, which looks cheap next to a software firm on 8.0. The comparison is meaningless, because grocery net margins run near 2% while the software firm keeps a fifth of every sale.
Example
An acquirer screening potential targets in industrial services uses enterprise value to sales rather than price to sales. Two candidates look identical on the equity measure until debt is included, at which point one turns out to be a third more expensive.
Think of it
“P/S shows market value relative to revenue-useful when there's no profit.
Formula
Calculation
Price to sales ratio = market capitalisation / annual revenue, which is the same as share price / revenue per share
A subscription software company has 40,000,000 shares in issue trading at $18.00, so its market capitalisation is 40,000,000 x $18.00 = $720,000,000. Annual revenue is $240,000,000.
The price to sales ratio is $720,000,000 / $240,000,000 = 3.0. Checking through the per share route, revenue per share is $240,000,000 / 40,000,000 = $6.00, and $18.00 / $6.00 = 3.0, which confirms the answer.
If a rival with the same $240,000,000 of revenue were valued at $480,000,000, its ratio would be 2.0, and the difference would usually be explained by growth rates or margins rather than by one company being obviously cheap.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Alder Lane Software, an invented workflow tools business, was valued at $720,000,000 on revenue of $240,000,000, a price to sales ratio of 3.0, while a listed rival sat at 5.5.
The founders assumed the market was undervaluing them and prepared a case for a higher rating. Their adviser pointed out that the rival grew revenue at 40% a year with a 78% gross margin, while Alder Lane grew at 12% with a 55% gross margin, and that the ratio gap was a fair reflection of those differences rather than an error.
The fictional board redirected attention from arguing about the multiple to improving the two things that drive it. Two years later, with growth at 25% and gross margin above 65%, the ratio moved to 4.4 without any change in how investors were being told the story.
Watch out
Common mistakes.
- Comparing price to sales ratios across industries, where different margin structures make the numbers incompatible.
- Forgetting that the ratio ignores debt entirely, so a heavily borrowed company can look cheap on this measure alone.
- Using a stale revenue figure from last year's accounts when the business has grown or shrunk sharply since the year end.
Questions
People also ask.
When is price to sales more useful than price to earnings?
When profits are negative, tiny or distorted by one off items, which is common for early stage and recovering companies.
What is a high price to sales ratio?
Above 4 is high for most sectors, though fast growing software businesses regularly trade well beyond 10 when growth expectations are strong.
Should I use enterprise value to sales instead?
Yes, whenever the companies being compared carry meaningfully different levels of debt or cash, because that version compares the whole business.
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