Investment strategy: Buying stocks with low price to sales ratios

The Price-to-Sales (or Price/Sales or P/S) ratio is defined as (Market Capitalization)/(Sales). The market capitalization is the current price of a share multiplied by number of shares. The sales is the revenue from sales for the previous year. This ratio could be also calculated as (Share price)/(Sales per share).

P/S ratio measure how much is the market willing to pay for the each dollar of sales. For example, if the P/E ratio is 15 then investors are willing to pay 15$ for each dollar of sales. Low P/S ratio might indicate that the company is either undervalued or in troubles. It is necessary to check other parameters to see which is true. Price / Sales could be used as a substitute for a Price to Earnings ratio when the earnings are negative. The Earnings could be negative because it is calculated as Sales-Expenses. It is important to compare P/S ratio to the P/S ratios of other companies in a given industry. It is also necessary to check for trends of this and other ratios. Some companies have cycles in earnings and sales. There might be more expenses in one year than in the previous one. At the same time the company might have more sales than in the previous year. In that case P/E ratio could be low or even negative, while the company is actually getting better.

It is important to notice that low Price to Sales ratio might mean that there is something fundamentally wrong with that company. Always assume that there is a reason why the company has small P/S ratio, and look for parameters confirming that. If you find little or no evidence that the company is in troubles, then consider this as a buy signal.