Better ROI with price-to-sales ratio investing strategies

“The price to sales ratio is the compass that navigates you through the ocean of overvalued and undervalued stocks. It may not always lead you to treasure, but it can certainly help you avoid the icebergs.” - Unknown

Introduction:

Many investors use price-to-sales ratio to identify opportunities. Does this ratio actually help traders win with more consistency?

In this article, we do a comprehensive research in the US stock market on how investors and traders could use the price-to-sales ratio to get a statistical advantage and stack the odds in their favor.

At the end, we give three tips backed up with 21 years of financial data.

Enjoy!

Price to Sales ratio definition

The price-to-sales (or price/sales, or P/S) ratio is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and divide it by the company's total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment.

According to this Investopedia article, Price-to-sales provides a useful measure for sizing up stocks.

Why one dollar has different value for different companies

Consider construction companies, which have high sales turnover, but (with the exception of building booms) make modest profits. Their P/S ratio could very well be quite low and yet their profitability may not be fantastic.

By contrast, a software company can easily generate $4 in net profit for every $10 in sales revenue. And so, a reasonable P/S for a software company can be very different than a reasonable P/S for a construction company.

Is P/S any useful?

If you compare similar companies, the P/S ratio becomes a tool for finding industry-relative value opportunities.

As I look at Apple and Microsoft, which are much more similar than for example Microsoft and Kohl's (and thus comparing P/S is more relevant), here's what I see (in January 2022):

Apple (AAPL): P/S = 7.31

Microsoft (MSFT): P/S = 12.86

(Just for reference, Kohl's (KSS): P/S = 0.47)

And so, if I would look at P/S alone, and I would need to choose between these two tech giants, I would pick Apple.

What is a good P/S ratio

The annoying answer is "well, it depends".

The more detailed answer could be something like "Look at the industry's average P/S and then look for companies where the P/S is lower than average and the revenues (and earnings) are growing preferably at least at average speed if not faster".

But if we just want rules of thumb and don't care about doing industry analysis...

There are certain P/S ranges that give a proven statistical advantage

The lower the price-to-sales ratio, the cheaper each dollar of revenue is. Simple logic dictates the "lower is better", and here's a little statistical study that proves the point.

Rules

1. Only look at companies with stock price higher than $1 to filter out the "craziest penny stocks"

2. Only look at companies with 20-day average daily trading volume at least 100,000 shares, to filter out the low-liquidity traps / rockets

3. The simulation verifies the P/S ratio at each Friday's close and stocks move between groups once per week at most. (Weekly candles.)

Results

The rightmost bar in the chart is the "benchmark", S&P500 index. The orange line is drawn at the benchmark level.

What the image above tells is that if an investor / trader sticks to companies with P/S ratio under 4, they are dealing with companies that have a tendency to outperform the broader market.

The lower the P/S becomes, the more likely the stocks in that group are to outperform the markets.

With S&P500 growing 7.30% on average each year between January 2000 and December 2021, the same period's annual average for stocks with P/S under 0.5 is 17.90%.

Sticking to stocks with P/S lower than 0.5 gives...

145% better annual average growth

That's certainly a number worth caring about.

Now, what about the industry averages?

Buy companies with lower than industry average P/S if you want to win

This time we simulate the more detailed scenario in which we look at the industry as a whole and define the median P/S ratio for the industry.

Rules

The basic rules are the same as above: penny stocks and stocks with no volume are out, and we look at weekly candles only for resolution.

Here are the different price-to-sales ratio filters for stocks within each industry

• 3 companies with lowest P/S and the P/S under industry median

• 10 companies with lowest P/S and the P/S under industry median

• Every company within the industry with P/S below industry median

• Every company within the industry with P/S above industry median

• 10 companies with highest P/S and the P/S above industry median

• 3 companies with highest P/S and the P/S above industry median

Results

Looking at the graph above, the result is clear: Picking the companies with the lowest P/S ratios in each industry you're invested in gives you a very clear statistical edge.

What comes to me as a surprise is seeing that picking the highest P/S ratios does not necessarily hurt the performance. Despite being surprised, that's what data tells and that's all I really care about when I'm looking for ways to improve my results. Opinions and hunches are not worth much in this game.

If we compare 22.40% annual growth to the benchmark 7.30%, this gives us...

206% better compound annual growth rate!

Can we do better?

Sure!

Information overload?

If you want to see how our winning method works in action, click here.

Strong revenue growth plus low price-to-sales ratio is a sure-fire way to dramatically increase your ROI... is it?

Let's do one more simulation with the same basic rules of no penny stocks, some volume required and renewing the stock list once per week at most.

Data sets

• 2 companies with highest P/S and the P/S above industry median (same logic as previously, simply tighter filtering)

• P/S below industry median, top 10 revenue growth, top 5 next fiscal year revenue growth estimate revisions by analysts and bottom 2 P/S (super complex)

• 3 companies with highest P/S and the P/S above industry median (same as in previous)

• P/S below industry median, top 10 revenue growth and bottom 5 P/S (somewhat complex)

• 10 companies with highest P/S and the P/S above industry median (same as in previous)

So now, instead of looking only at current numbers, in the most complex case we also look at what stock analysts think about the future, and we pay special attention to when they improve their estimates.

And just to make sure we're not complicating the simulation just for fun, we throw in a yet-untested tighter version of the previous simulation: 2 companies with the lowest P/S ratios from each industry.

Results

Take a close look at that graph.

By adding increasingly complex screening criteria for stocks, I managed to improve results marginally...

While simply being more selective on the P/S screening alone beat the more complex cases.

What's worth noting is that the two leftmost bars both end with choosing the 2 stocks with the lowest P/S ratio in their industry. And it appears that looking at realized and expected revenue growth before picking the two winners actually makes the results worse!

Three tips for increase your trading ROI using P/S ratio and revenue growth

Here's what we discovered by going through 21 years of financial data.

1. Lower P/S is better than higher P/S

2. Picking stocks with P/S under 4 statistically outperforms the markets

3. Picking the lowest P/S stocks in each industry outperforms the industry. The tighter the selection within the industry, the bigger the advantage.

A bonus tip could be this: when it's possible to keep it simple, do that. While mixing in revenue growth and revenue growth estimate requirements felt like a winning idea, verifying the thesis proved it to be wrong.

Trust data.

Why P/S alone is not enough

Investopedia claims that revenue is valuable only if, at some point, it can be translated into earnings. A company could be going bankrupt due to high debt and rapidly increasing interest rates.

And while this is certainly true... can we prove that with numbers?

In the next article, we will take a look at P/E ratio and how to use it for your proven advantage.

Need a shortcut?

If you want to make your investing and trading life easier, you may wish to go to this page and try our Monthly Focus Lists, a relaxed fundamentals-based stock selection method that uses P/S ratio and other criteria to build and maintain a portfolio with a statistically proven edge.

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Here's their performance for the past 20 or so years, benchmarked against S&P 500 (updated to include 2022 so you see how the method endures stress):

If that's something you think you could like, why not try?

To your consistent profitability,

Jukka and Option Investors Club

PS.

If you scrolled to the end to get the tips, here's the three tips based on what we discovered through this article by going through 21 years of financial data.

1. Lower P/S is better than higher P/S

2. Picking stocks with P/S under 4 statistically outperforms the markets

3. Picking the lowest P/S stocks in each industry outperforms the industry. The tighter the selection within the industry, the bigger the advantage.

If you want a shortcut to improving your ROI, visit this page.