Determining the Right Stock Price
Many times the market doesn't price a stock in a realistic way. One way to find whether the market has undervalued or overvalued a particular stock is by using the price/sales ratio.
A good candidate for investment is a stock that has a room for further growth. Before you decide whether to invest in it or not, you should determine its growth potential by comparing it to the stock of the companies from the same industry or sector. If the stock's price is relatively lower than the ones of its peers, then you can confidently consider the investment in this stock.
However, many times the market overvalues stocks. In such a case the most possible outcome is for the price to start to go down. On the other hand, this is not a must and many times if the price is financially beneficial you can still purchase the stock.
In order to make more reasonable decisions regarding the viability of an investment you can use the price/sales ratio. It will also help you identify in which category the stock falls.
If you are an inexperienced investor it will be difficult to make any sense out of the numbers quoted for the stocks' prices.
Having just the prices of two stocks may make it more difficult to determine which one of them represents a better deal. Additional knowledge about the companies that issue the stocks is needed. For example, if stock A's price is higher than stock B's price, then it may mean that company A is a better company than company B since it is more expensive. On the other hand, it may also mean the company B is undervalued and represents a bargain.
So, the formula for the price/sales ratio is:
Price/sales = Market Capitalization / Company Revenue
Market Capitalization = (Number of Shares Outstanding) x (Price per Share)
This ratio allows for the comparison of companies from the same industries. The lower the result of the ratio is the better. We want to stress once again that the ratio should be used only to compare companies from the same industries. This is required since there are major differences among the various industry groups of companies.
Price/Sales Ratio Implications
What exactly the price/sales ratio tells us?
Let's consider the following example. Stocks of company A have a price/sales ratio of 1.5, whereas stocks of company B have a price/sales ratio of 1.9. On the other hand, the average price/sales ratio for this industry group is 2.5.
As it can be seen, stock A and stock B are sold under the average level for the industry in which they fall. Stock A, which has a price/sales ratio of 1.5 represents the better deal since it is lower than the one of stock B.
In order to make a more reasonable decision regarding which stock to purchase you should include other criteria in your analysis. One of them is the price earnings ratio (P/E).
There are cases in which the price/sales ratio and the P/E ratio don't coincide regarding the suitability of the stock. If this occurs you should check for an event that might have caused the distortion.
If you don't have the time and information to calculate on your own these ratios, you can always retrieve them from one of the many online sources.
The price/sales ratio facilitates your work in finding the right price at which to purchase a stock. A good investment decision includes picking the right stock and purchasing it at the most beneficial price.
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