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Tuesday, June 15, 2010

How to use the Market Cap to Sales (or Price to Sales) ratio to value stocks

Before learning when and how to use the Market Cap to Sales (or Price to Sales) ratio, some definitions may be in order.

Market Capitalisation (Market Cap) = Total number of equity shares x Price per share

If the equity capital of a company is Rs 10 Crores and the face value of each share is Rs 10, then the company has issued 1 Crore shares. If the share price is Rs 50 (on a given day), the Market Cap (on that day) is Rs 50 Crores. As is evident, the Market Cap is a number that changes with the share's price.

Why should we be concerned about this number? It represents the total value of the company in the stock market. In other words, if you had a lot of money and you wanted to buy the entire company (which has to be listed in the stock exchange), then you will have to pay an amount equal to the Market Cap, i.e. Rs 50 Crores.

The Market Cap to Sales ratio, also referred as the Price to Sales ratio (P/S or PSR), is calculated by either dividing the Market Cap by the total sales of the previous 12 months, or by dividing the share price by the per-share sales of the past 12 months.

P/S or PSR = Price per share/Sales per share = Market Cap/Total Sales

If the company in our example had sales of Rs 80 Crores in the previous year, its Market Cap to Sales ratio will be 50/80 = 0.625. A ratio less than 1 is considered a sign of 'under-valuation'. Why? It means that for each Re 1 of sales you will be paying 62.5 paisa if you were buying the entire company.

If another company in the same sector has a similar equity capital, but a share price of Rs 60 and sales of Rs 100 Crores, then its Market Cap to Sales ratio will be 60/100 = 0.6. That means, the higher priced share is actually 'cheaper' valuation-wise.

This is an important point for small investors to note. Many say that they have limited capital and therefore, opt to buy shares that are cheaper in price. They end up buying a small cap or mid cap share. Valuation-wise, a higher priced large cap may be a better buy.

Please remember that different sectors have different operating criteria. Some require heavy capital expenditure, others don't. Some sectors have low sales and high profit margins. Others have large sales but low profit margins. The Market Cap to Sales ratio should be used only for comparing companies within the same sector.

Several other ratios, like Debt to Equity, Interest Coverage and Return on Assets, had been discussed earlier. Do we really need to look at another ratio? The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses. Because they have no earnings, the more popular valuing metric P/E can not be used.

As a general thumb rule, small investors should avoid loss-making companies. What if an otherwise fundamentally strong sector or company gets into a temporary difficulty and incurs losses? It happened to Tata Motors and Hindalco. It happened to the export-oriented textile sector. The Market Cap to Sales ratio will help to separate the men from the boys.

Many analysts prefer to use the P/S ratio over the P/E ratio, because it is easier to fudge earnings, whereas sales can be more readily verified. That does not mean a 'creative' company like DLF can't fudge their sales figures!

It is best to check both the P/E and the P/S ratios when selecting a company from a particular sector. If both indicate 'under-valuation', then the stock can be included in a 'buy' list. If the indications are contrary to one another, it is an alarm signal that management is probably doing some fudging.

Debt-burdened companies often trade at low Price to Sales ratios. Their sales may not be affected and may actually be growing, but interest and capital repayments may be causing a drop in margins and cash flows. Investors should avoid such 'value traps' by checking the Debt/Equity and Interest Coverage ratios.

(A short exercise for readers: In the recent stock selection exercise, most readers chose Stock 'N' as the best of the three. However, on the basis of the Market Cap to Sales ratios, Stock 'N' is more expensive with a ratio of 0.79. Stock 'S' and Stock 'I' have ratios of 0.47 and 0.46.

Will readers still choose Stock 'N' over the other two? If yes, why? If no, why not?)


Ravi said...

I work in Multi-National company. My CEO has strong interest on stock trading (US Market). He said following additional points related to price/sales ratio.

1. Choose a fundamentally strong stock. If we are comfortable with a company like reliance (with very long term view), then we can keep on selling and buying stocks of that company based on Price/Sales Ratio.

2. This selling/buying does not happen on daily basis or weekly basis. So, it is not a short term trading.

3. When Price/Sales ratio for the stock of interest goes below < say 0.30 (example only to indicate buy at low), then it becomes a buy and hold.

4. If it goes > .80 (again an indication only) sell.

5. When we plot a chart with all Price/Sales rations over a period of time(for various quarters based on results) for any stock we can see the cyclical nature of the price/sales ratio.

6. We can also get the general range of that particular stock for price/sales ratio.

That way we don't have just buy and keep holding a stock, rather take the benefit of medium term (couple of years) movement in that stock.

Request you to validate this view.

Titu said...

Hello Sir,

Every time I visit this blog I learn something new, thanks for sharing your knowledge.

About short exercise for readers I still prefer stock “N”, because you told The Market Cap to Sales ratio is particularly useful in valuing companies which are incurring losses, and we are not discussing loss making companies, so I will give more importance to dividend yield and long term uptrend.

Am I right or wrong? Please guide!!


Subhankar said...

@Ravi: Thanks for your comments.

Your CEO is obviously a market veteran and his system of using the Price to Sales ratio to buy and sell makes eminent sense.

I've never used the ratio for buy/sell decisions because I generally avoid loss-making stocks. But I do use the P/E ratio in almost an identical fashion.

@Titu: Appreciate your kind words.

You are quite correct - the selection criteria doesn't change in this case due to the higher Market Cap to Sales ratio. But the timing does. You may want to wait for the price to come down a bit before buying.