P/S and P/CF Multiple

P/S Ratio

The advantages of using the price to sales (P/S) ratio include:

• P/S is meaningful even for distressed firms since sales revenue is always positive. This is not the case for P/E and P/B ratios, which can be negative.
• Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions.
• P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis when earnings for a particular year are very high or very low relative to the long run average.
• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start up companies with no record of earnings. It is also often used to value investment management companies and partnerships.
• Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in long run average stock returns.

The disadvantages of using P/S ratios include:

• High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash flow.
• P/S ratios do not capture differences in cost structures across companies.
• While less subject to distortion, revenue recognition practices can still distort sales forecasts. For example, analysts should look for company practices that speed up revenue recognition. An example is sales on a bill and hold basis, which involves selling products and delivering them at a later date.
• This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

P/S multiples are computed by dividing a stock’s price per share by sales or revenue per share, or by dividing the market value of the firm’s equity by its total sales:

P/CF Ratio

Advantages of using the price to cash flow (P/CF) ratio include:

• Cash flow is harder for managers to manipulate than earnings.
• Price to cash flow is more stable than price to earnings.
• Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for P/E.
• Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long run average stock returns.

There are two drawbacks to the price to cash flow ratio, both of which are related to the definition of cash flow. We discuss the specific cash flow definitions next.

• Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored.
• From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative.