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Comparing companies' sales on an apples-to-apples basis hardly ever works. Examination of sales must be coupled with a careful look at profit margins and their trends, as well as with sector-specific margin idiosyncrasies.
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Debt Is a Critical Factor A firm with no debt and a low P/S metric is a more attractive investment than a firm with high debt and the same P/S. At some point, the debt will need to be paid off, so there is always the possibility that the company will issue additional equity. These new shares expand market capitalization and drive up the P/S. Companies heavy with corporate debt and on the verge of bankruptcy, however, can emerge with low P/S. This is because their sales have not suffered a drop while their share price and capitalization collapses. So how can investors tell the difference? There is an approach that helps to distinguish between "cheap" sales and less healthy, debt-burdened ones: use enterprise value/sales rather than market capitalization/sales. By adding the company's long-term debt to the company's market capitalization and subtracting any cash, one arrives at the company's enterprise value (EV). Think of EV as the total cost of buying the company, including its debt and leftover cash, which would offset the cost. EV shows how much more investors pay for the debt. This approach also helps eliminate the problem of comparing two very different types of companies:
1. The kind that relies on debt to enhance sales and 2. The kind that has lower sales but does not shoulder debt. The Bottom Line As with all valuation techniques, sales-based metrics are just the beginning. The worst thing that an investor can do is buy stocks without looking at underlying fundamentals. Low P/S can indicate unrecognized value potential - so long as other criteria like high profit margins, low debt levels and growth prospects are in place. In other cases, P/S can be a classic value trap.
by
Ben McClure
Ben McClure is a long-time contributor to Investopedia.com. A specialist in preparing early stage technology ventures for investment and the marketplace, Ben manages the Business Incubator at the University of Malta. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at TEC Edmonton, a major technology commercialization consulting group in Canada.
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