May 26, 2010 | In: Stock Market
How to Purchase Stocks with Low P/S Ratios
If you are not familiar with the term yet, the Price/Sales or P/S ratio is computed by dividing market capitalization by sales. Market capitalization is defined as the current price of a stock multiplied by the number of stocks. The sales, on the other hand, refer to the income from sales made in the past year. Another way to calculate the P/S ratio is to divide the stock price by the number of sales per stock.
Essentially, the P/S ratio determines the amount of money that stock traders can afford to pay for every dollar of sales. For instance, if the ratio is 15, then stock investors may be willing to spend 15 cents for every dollar of sales. If a company’s P/S ratio is low, it means that the company may be in financial trouble or undervalued. To know which of the two conditions is true in a company with a low P/S ratio, it is important to assess other indicators. When a company’s earnings are negative, then the Price/Sales ratio can be used as an alternative to Price/Earnings ratio. Earnings that are calculated as Sales-Expenses usually get a negative value. Comparing P/S ratio to the ratios of other companies within the same industry is very important. Checking the trends of these ratios is necessary as well. A number of companies experience earning-sale cycles, in which there are more expenses or sales in a specific year than in the preceding year. If a company has more sales this year than in the previous year, its P/E ratio could be negative despite the company’s good financial situation.
A low P/S ratio may be a sign that something goes wrong with a company. As an investor, you must look into factors that triggered such a low ratio. Once you have found out that there is no proof that a company is facing troubles, then it is a good sign to buy its stocks.
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