The PSR: A tool for stock valuation

The price-to-earnings (P/E) ratio is a popular tool that many investors use to get a rough idea of a stock’s valuation — to see whether it looks overvalued, undervalued, or fairly valued.

If a company has no earnings, though, a P/E ratio can’t be calculated. Instead, the priceto-sales (P/S) ratio, sometimes called the PSR, can be used, as it focuses on sales (also known as revenue). Even with a profitable company, you might check the PSR.

Calculating a company’s PSR is fairly easy: You simply take its market capitalization and divide it by the company’s sales over the past 12 months. The “market cap” reflects a company’s current market valuation — it’s the current price per share multiplied by the total number of shares outstanding. You can find market caps listed for companies on major financial websites such as Fool.com and Finance.Yahoo. com. (Finance.Yahoo.com presents each company’s P/S ratio, too, under its “Statistics” tab.)

Here’s how you would crunch the PSR yourself: Let’s say the Free-Range Onion Company (Ticker: BULBZ) has 20 million shares outstanding, at $25 a share, giving it a market capitalization of $500 million. If it had $1 billion in sales over the last year, its PSR would be $500 million divided by $1 billion, which equals 0.5. If its peers have PSRs of 1.0 or higher, Free-Range Onion’s PSR of 0.5 suggests that it’s more attractively valued and likely to have a substantial upside relative to its rivals — if it executes its strategies successfully.

It’s not uncommon for companies to be unprofitable in some years, and you needn’t avoid such enterprises entirely. By checking the PSR, you can see how much you’d be paying for a dollar of sales instead of a dollar of earnings. Compare the PSR with sales growth, too: A high PSR isn’t necessarily bad if sales are growing rapidly.

Understand, though, that you should never rely on just the PSR — or any other single measure — when making an investment decision. Assess a wide variety of measures.