Which one of the following describes a drawback of Price/Sales valuation method? Select one: a. Stock repurchases or issuances can distort historical comparisons. b. The Price/Sales ratio does not capture differences in cost structures among companies. c. Research shows that the Price/Sales ratio explains the long-run average stock returns. d. Sales revenue as a cumulative amount is generally positive, even when EPS is negative or zero.
The correct answer and explanation is:
The correct answer is b. The Price/Sales ratio does not capture differences in cost structures among companies.
Explanation:
The Price/Sales (P/S) ratio is a valuation tool that compares a company’s market capitalization (price) to its revenue (sales). The basic premise of this ratio is that sales figures are generally more stable than earnings, which can be volatile. However, the P/S ratio has several drawbacks, one of which is the inability to account for the differences in cost structures between companies. Here’s why:
- No consideration of profitability: The P/S ratio only looks at total revenue and divides it by the market cap of a company. It does not take into account whether a company is generating profit or incurring losses. Two companies with the same sales figures may have vastly different profit margins based on their cost structures. For instance, one company might have high operating costs, while another could be more efficient with lower costs. The P/S ratio does not capture these variations in cost efficiency, which can lead to misleading comparisons.
- Limitations for different industries: In some industries, high sales volumes may be more closely associated with low profit margins, while in others, even moderate sales can result in high margins. The P/S ratio does not differentiate between these scenarios, making it harder to use across different sectors without further analysis.
- Risk of overvaluation: Without considering costs, a company with high sales but high costs could appear overvalued based on the P/S ratio. Similarly, a company with low sales but more efficient operations could be undervalued. This is why the P/S ratio is not always the best indicator of true company value.
While the P/S ratio has its merits, such as being useful when companies are not profitable or have negative earnings, it’s important to remember that this ratio overlooks key aspects like profit margins and operating efficiency.