Price to Sales Ratio: What It Measures, a Worked Example and When to Use It

The price to sales formula

Price to sales = market capitalisation ÷ revenue (last twelve months)
EV to sales = enterprise value ÷ revenue

Use the equity version when the question is what shareholders pay per dollar of sales and the enterprise version when comparing companies with different debt levels, since revenue belongs to the whole business before interest. Trailing twelve-month revenue is the convention; forward revenue multiples are common for fast-growing companies and inherit every error in the forecast. The enterprise value vs market cap article covers the numerator choice.

Worked example: two companies (illustrative)

Harbor Foods and Zenith Software are fictional. Zenith costs five times as much per dollar of revenue, which looks absurd until the rest of the table is read: it converts a slightly larger share of each dollar into profit and is growing seven times as fast, so each dollar of its revenue today is expected to become several dollars in a few years. Whether 5× is justified depends entirely on whether that growth continues and whether the margin expands as the company scales, which is what the implied growth rate article tests directly. Harbor's 1.0× is not cheap in isolation either; it is a 12.5× P/E dressed differently.

The margin arithmetic: what multiple of sales a company deserves

Price to sales = net margin × P/E

Because net income is revenue times net margin, the sales multiple is just the earnings multiple scaled by the margin. A company that deserves 20 times earnings deserves 2 times sales at a 10% margin, 1 times sales at a 5% margin and 4 times sales at a 20% margin. This is why a grocer at 0.3× sales and a software company at 8× sales can both be fairly priced, and why comparing sales multiples across industries without the margins is meaningless. For a loss-making company the same identity runs forward: the question is what margin the business will earn at maturity and what earnings multiple that profit will deserve. Zenith at 5× sales needs, say, a 25% mature margin and a 20× multiple, which together justify 5× sales, so the price is a forecast that margins will more than double. The good P/E ratio article covers the second factor and the operating margin formula article the first.

Reading a company against its own history

Because margins change slowly in most businesses, a company's sales multiple against its own five-year range is often more informative than the multiple against a peer. A consumer company that has traded between 1.2× and 2.0× sales for a decade and now sits at 1.0× is either cheaper than it has ever been or the market has decided its margin is going to be lower from here, and the two explanations call for opposite actions. The margin trend settles it: if operating margin is stable, the multiple is the opportunity; if the margin has been falling for three years, the multiple is simply catching up. Zenith's 5× sales, read the same way, means little in the company's first years, when the margin has no history, which is why the multiple for a young company is a forecast rather than a comparison.

When price to sales is the right tool

• Loss-making companies. With no earnings and negative cash flow, revenue is the only line that scales, and the multiple can be paired with a view on the margin at maturity.
• Cyclical troughs. A steelmaker or a homebuilder at the bottom of its cycle has depressed or negative earnings and a P/E that says nothing; its sales multiple against its own history shows whether the market is pricing recovery.
• Turnarounds. When a company's earnings are temporarily broken, the sales multiple relative to peers with normal margins shows what the business would be worth if the margin were fixed.
• A cross-check on earnings quality. Revenue is harder to manage than profit, so a company whose earnings multiple looks cheap while its sales multiple looks ordinary may be reporting unusually high margins that will not last.

Traps

• Gross versus net revenue. A marketplace that reports the full value of goods sold through it has a sales multiple a tenth of one that reports only its commission, for the same business. Read the revenue recognition note.
• Pass-through revenue. Distributors, staffing firms and fuel retailers book revenue they immediately pay out; their sales multiples are tiny and their margins are tiny for the same reason.
• Acquired revenue. A company that bought a business mid-year shows a jump in revenue that its market cap already paid for, and in debt; use EV to sales and full-year pro forma figures.
• One-off contracts. A large non-recurring sale depresses the multiple for a year.
• Growth at any price. A high sales multiple is a claim that growth and margin expansion will both arrive. Many have not. Pair the multiple with the cash burn, the path to profit and the dilution that funds it; the priced for perfection article covers the pattern.

The stock valuation guide places the sales multiple at the bottom of the toolkit, to be used when the better tools cannot be. VALYSTR's Discover shows sales, earnings and cash-flow multiples side by side with the margin, so the comparison that gives the ratio its meaning is on the same screen.