Question

Name and briefly discuss any two of the three flaws of the price-to-sales ratio, which is used in the valuation of target companies?

Answer 1

The P/S ratio shortcomings :

• Possibilty of manipulation: The P/S ratio is not immune to manipulation : It can be less prone to accounting manipulation. Even though sales are difficult to manipulate, it's not impossible.
• The P/S ratio cannot be used as a single metric for valuation : The numerator in the formula P/S reflects the capital structure but the sales figure does not reflect the impact of financing , as a result there is a disconnect between these two variables. It does not give any idea about a company's profitability and cost structure. P/S should never be the sole metric used when valuing a company. For example, a business may have higher sales but a lower profit margin than a competitor, indicating that it's not operating efficiently.
• Does not take into account the changes of capital structure: The revenue per share figure does not capture the effect of capital structure or the cost of capital. This ratio can capture the sales part but it cannot capture the differences in the cost structure. Only high revenue is not enough, the high revenue has to converted into high net income. Sometimes the costs are so high, that the resultant net income is very low. So, the P/S ratio is unsuccessful in distinguishing between a leveraged and a unleveraged company.