It does not matter how popular a company may be with investors. It does not matter how much of a household name a company may be. It does not matter how long a company has been in business. If a company’s stock is over-priced, it typically goes only one direction. Down. Sure, the company may be a great business, and could even be a good investment candidate. But if the stock is currently over-priced, it isn’t the right time to invest in that company.

 

So, when should a company’s stock be bought? How do you know the right price? One way to figure it out is to calculate the Price to Sales Ratio.

 

Stock prices can be all over the place, like these fictitious companies:

Pear Computer, Inc. ………… $54.27

Fastway Computers ………… $38.12

 

Both companies are in the same industry: Personal computer manufacturers.

Is Pear Computer the better investment because its stock price is higher, or is Fastway better because it’s such a bargain? What do these stock prices tell you about these companies? Absolutely nothing! If you don’t know anything about a company, the stock price really means nothing to you.

 

In order to determine which one of these companies is the better investment, you must have a way to compare them, “apples to apples”. Using the price to sales ratio is a metric that allows you to compare multiple companies within the same industry. The calculation is quite simple. You take the company’s market capitalization and divide it by its revenue.

 

Market capitalization: The number of outstanding shares multiplied by the share price.

Revenue: Income that a company receives from its normal business activities.

 

Example:

Shares outstanding: 890,000,000

Share price: 54.27

Market cap: 48.3 Billion

Revenue: 33 Billion

Price to Sales Ratio: 48.3B / 33B = 1.46

 

Shares outstanding: 330,000,000

Share price: 38.12

Market cap: 12.6 Billion

Revenue: 4 Billion

Price to Sales Ratio: 12.6B / 4B = 3.15

 

The calculated price to sales ratio gives you a number that can be used to compare these two companies on an even playing field. The lower the number is, the better the investment. The price to sales ratio can only be used to compare companies within the same industry. For example, you can’t accurately compare a restaurant and a bank using this ratio.

 

By using the price to sales ratio, you can see that Pear Computer is currently a better buy than Fastway Computers even though Pear’s stock price is significantly higher than Fastway’s. Fastway may be a very good company but, at the current prices, Pear Computer has more value and is a better investment.

 

You can find the information to calculate the price to sales ratio at www.google.com/finance

Enter the stock symbol in the “get quotes” box and click on the Get quotes button. A detailed screen will be displayed showing that company’s financial information. From there you will find all the information needed to make the calculations.

 

There are two parts to making a successful investment:

1. Pick the right stock

2. Buy it at the right price

Using the price to sales ratio will help you determine if the price is right.