THE ONCE-OBSCURE price/sales ratio has become an increasingly popular method of valuation for a few reasons. First, quantitative investor James O'Shaughnessy demonstrated convincingly in his book, "What Works on Wall Street," (McGraw-Hill, 1998), that stocks with low PSRs outperformed stocks with low P/E multiples. Second, as we mentioned in the section on P/Es, many investors don't trust net earnings, since they are often manipulated through writeoffs and other accounting shenanigans. Sales are much harder to "manage." Finally, the explosion in Internet stocks forced investors to look for ways to value companies with lots of potential, but no earnings.
As the name implies, the price/sales ratio is the company's price divided by its sales (or revenue). But because the sales number is rarely expressed as a per-share figure, it's easier to divide a company's total market value by its total sales for the last 12 months. (Market value = stock price x shares outstanding.)
Generally speaking, a company trading at a PSR of less than 1 should attract your attention. Think about it: If a company has sales of $1 billion but a market value of $900 million, it has a PSR of 0.9. That means you can buy $1 of its sales for only 90 cents. There may be plenty else wrong with the company to justify such a low price (like maybe it's losing money), but that's not always the case. It might just be an overlooked bargain.
O'Shaughnessy found that PSRs work best for large-cap companies, perhaps because their market values tend to be much closer to their massive sales to begin with. The ratio is less appropriate for service companies like banks or insurers that don't really have sales. Most value investors set their PSR hurdle at 2 and below when looking for undervalued situations. But, as always, we'd counsel that you compare a company's PSR value to its competitors and its own history.