What you need is not a lot of action, but a lot of patience. You must stick to your principles, wait for the opportunity to come, and then seize it with all your might.
— Charlie Munger

Previously, we discussed Price-to-Earnings Ratio (P/E) and Price-to-Book Ratio (P/B). But soon, you'll encounter a problem: if a company isn't profitable or is even losing money, P/E becomes useless. If it's a software company with few fixed assets, P/B won't tell you much either. So, what should you do then?

The answer: we can look at a simpler metric—Price-to-Sales Ratio (P/S).

P/S is like a backup tool that comes in handy when P/E and P/B don't work. It's simple to use, but it also has its pitfalls. Today, we'll break it down clearly.

1. What is Price-to-Sales Ratio (P/S)?

The formula is straightforward:

Price-to-Sales Ratio (P/S) = Total Market Cap / Total Sales Revenue

or

Price-to-Sales Ratio (P/S) = Share Price / Sales per Share

Its meaning is even simpler: it tells you how many times the company's market cap is compared to its annual sales revenue.

For example, if a company has a market cap of 10 billion and annual sales revenue of 5 billion, its P/S is 2x.

Compared to profits, sales revenue has two key characteristics:

More stable: Profits can fluctuate wildly due to costs and expenses, but sales revenue (how much a company sells) is usually much more stable.

Harder to manipulate: It's much harder to fudge sales revenue than profits, so it better reflects a company's actual business performance.

2. When Should You Use Price-to-Sales Ratio (P/S)?

P/S is particularly useful in the following three scenarios:

1. Valuing Unprofitable "Growth Stocks"

This is the most common use case. Many new tech companies lose money early on because they spend heavily on advertising and user acquisition. In such cases, P/E is negative and useless. But as long as they have revenue, we can use P/S to value them and compare them with peers to gauge how the market is pricing their growth potential.

2. Identifying the Bottom for "Cyclical Stocks"

Industries like steel and chemicals go through boom-and-bust cycles. When business is bad and they're losing money, P/E becomes meaningless. But as long as they're still producing and selling, they have sales revenue. If their P/S falls to historically low levels, it could signal that the industry is nearing a bottom.

3. Spotting "Recovery Stocks" in Trouble

Some good companies may temporarily fall into losses due to short-term issues. If their brand and sales channels remain intact, we can use P/S to assess whether the market is overreacting. If P/S drops to an unreasonably low level, it might be a good opportunity to buy cheap.

3. Three Pitfalls to Avoid When Using Price-to-Sales Ratio (P/S)

Now, the important part: P/S can easily lead you astray if misused.

Pitfall 1: Focusing Only on Revenue, Ignoring Profits

This is the biggest trap! High sales don't mean the company is profitable. If a company loses money on every sale, higher sales just mean faster destruction of value.

Ask yourself: Is this company making money normally, or is it just burning cash for growth?

Pitfall 2: Focusing Only on Sales, Ignoring Debt

P/S only cares about how much a company sells, not how much it owes. Two companies with the same sales revenue can have vastly different risks if one is debt-free and the other is drowning in liabilities.

Pitfall 3: Comparing Across Industries Blindly

Different industries have different profit margins, so P/S can't be compared directly.

Example: You can't compare the P/S of a software company (high margins) with a supermarket (low margins)—it's meaningless. P/S should only be used for companies with similar business models.

4. Case Study: Webvan—A Cautionary Tale of "Growth at All Costs"

Webvan was a star company during the late 1990s dot-com bubble. It sold groceries online and promised one-hour delivery. The concept was hugely appealing, and the company raised massive funding, going public in 1999 with a peak market cap of nearly $8 billion.

Valuation vs. Reality

Because Webvan was in rapid expansion mode, its sales grew explosively, but it was also losing money heavily. P/E was useless, so investors relied on P/S, assigning a huge premium to its sales growth. They believed that as long as Webvan kept growing sales, it would eventually turn profitable, justifying its high valuation. To them, the P/S was "reasonable" for a company poised to capture a trillion-dollar market.

Fatal Flaws

Webvan's business model was fundamentally flawed. It spent billions building expensive automated warehouses and delivery fleets, driving up costs. Analysis showed that for every $100 in orders, Webvan incurred $130 in costs. It wasn't making money—it was losing money on every sale.

Management believed in "economies of scale," thinking higher order volumes would reduce per-order costs. So, they used IPO proceeds to expand even more aggressively.

Outcome

When the dot-com bubble burst in 2000 and capital markets stopped funding loss-making companies, Webvan's cash flow dried up. In 2001, the former star collapsed into bankruptcy.

Lesson

Webvan is a painful lesson: sales growth that doesn't lead to profits is worthless—it's poison. When using P/S, if a company's business model can't generate profits, even a low P/S is a dangerous trap. Investors must look beyond sales to assess real profitability.

5. Summary

P/S isn't a perfect metric. Think of it like a car's throttle:

Pressing the throttle (increasing sales) makes the car move, but you also need to watch the RPM and fuel gauge (profit margins) and ensure the engine (business model) is sound, not about to fail.

So, a smart investor uses P/S like this:

1. It's a supplementary tool, not a core one. Ultimately, value comes from profits and cash flow.
2. Track P/S trends, but also watch if profit margins are improving. If P/S stays flat but margins rise, that's a very positive sign.
3. Most importantly: Can this company eventually make money? P/S is just a temporary lens when profits are unclear. Your investment decision must be based on long-term profitability.

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Disclaimer

This article reflects the author's personal understanding and sharing of learning materials, with AI assistance during the writing process. All content is for educational purposes only and does not constitute any form of investment advice or basis for investment decisions. Investing carries risks, and caution is advised. Please think independently and take responsibility for your investment decisions.