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Price-to-Sales ratio : Unearth the hidden diamonds

Many parameters have to be ascertained before you can say "good buy" to a particular stock... or smartly bid it a "good bye". In the past, I have already touched upon these pivotal qualities of an equity share that can deliver stunning returns.

The world's most successful investors and fund managers use some mix or the other, of these key attributes, to identify the stocks they would like to pick up.

Among these, Price-to-Sales ratio ranks as one of the important characteristics.

Also termed as Market Cap-to-Sales ratio, the formula to calculate the same is as under:

Price-to-Sales ratio = Market price per share / Sales per share
                            or = Market Capitalization / Annual Sales

Effectively, it tells us how much the market is currently paying for each rupee of sale. Therefore, lower the ratio the better it is... a ratio of less than 1 indicates that the company could be undervalued.

This ratio was pioneered by noted stock market expert Mr. Kenneth L Fisher. He observed that the earnings or profits of a company were not only more volatile but also prone to manipulation as most investors focussed on the profits. Comparatively speaking, Sales were a lot more stable and relatively a reliable number (of course, not always with Enron being the classic example of fudging the sales).

Surely, not every company with volatile profits is a suspect. Cyclicals go through phases of low and high profits, despite the sales showing a steady trend. And it is typically with these cyclical companies that Price-to-Sales ratio becomes a really useful number to evaluate. Or take the case of companies aggressively targeting growth in the market share, which may affect their profitability in the near term. But this may ultimately translate into higher earnings in the future.

Further, as you would have noted, this is one metric that is quite useful in valuation of loss-making companies. Hence it aids in identifying the likely turnaround stories.

Of course, no single metric presents a true and complete picture. Profits, despite being open to mischief, are an important number. Hence, one cannot ignore the EPS, PE, PEG, ROE and such other earnings-based ratios totally and solely base one's investment decision on Price-to-Sales ratio.

For example, both Price-to-Sales ratio and PEG ratio should tell the same story. However, if one number indicates under-valuation and the other is not consistent with it, you need to look deeper into the numbers. There could be chances of doctoring somewhere. [Read 'Don't get conned by "doctored" EPS'].

Secondly, Price-to-Sales ratio works well for comparison of companies within the same industry or sector. Given vastly different business dynamics across different sectors, it may not deliver the right conclusions for inter-sector comparison.

Thirdly, debt is a significant factor, which is not captured by the Price-to-Sales ratio. Hence, it has to be interpreted alongwith the debt-equity ratio.

In short, though Price-to-Sales ratio has the potential to uncover possible multi-baggers, it needs to applied with caution.

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