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April 3, 2007
Price To Sales Ratio

For those of you who are value stock investing, I am going to put in your hands one of the most important weapons you could have; in reality, this is an excellent tool for anyone who is searching for good investments. Value investing involves looking for stocks that, for whatever reason, the market has undervalued. The price to sales ratio is perfect for this and something that you need to learn today.

The key to price to sales ratio is the concept that it is critical to know if a stock still has room to grow before you invest your money. If the stock is reasonably priced or under-priced and you have confirmed its growth prospects, you have found your next potential purchase. On the other hand, a stock that is over-priced won’t do anything but drop. You may want to purchase this company but only after the stock market has found its true value. Price to sales ratios can help you to make that determination.

The Better Bargain
Here’s the perfect place for a pop quiz? Which is a better purchase…IBM at $94.00 a share or Dell at $44.00? Your gut will tell you that IBM must be a better company because its stock is more expensive. Here’s the paradox; stock prices don’t really tell you much. If you don’t know anything about the two companies, you just cannot make a judgment based on price. This is where price to sales ratio can help you with your investment strategies.

Calculating Price to Sales Ratio
The price to sales ratio creates a metric that allows you to compare companies in the same stock sector. To calculate price to sales ratio you need to divide the market cap of a company by its revenue. Market cap is the number of outstanding shares multiplied by the per share price. If a company has 10 million shares outstanding and the per share price is $100, the market cap of the company is $1 billion.

By dividing this number by the revenue, you get a number that is consistent and can be used to compare different companies. You are looking for the lowest number here. It is also important that you only use the price to sales ratio to compare companies in the same industry since there will be differences among industry groups.

What is the Result?
Let’s go back to our pop quiz. IBM’s price to sales ratio in this example is 1.7 and Dell’s price to sales ratio is 2.2; the ratio for the industry group was 2.8. Both companies were selling under the same stock sector but IBM’s number was better than Dell’s. Looking at their price to earnings ratio, IBM’s P/E was 20 and Dell’s was 34.5, with the industry average at 33. Once again, IBM appears to be the better value. If the numbers here had conflicted, there is a very good possibility that something questionable had happened in one of the company’s books; look for a one-time event that has temporarily skewed the numbers.

There are two parts to successful fundamental and technical analysis: picking the right company and buying at the right price. The price to sales ratio is one tool that will help you determine if “the price is right”.

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