Hi fellow investors,

This is Charlie Tian again. I am very glad to be back. Last time I discussed the price-earnings ratio. I told you that the lower it was, the better, but that it does not work well for cyclical companies. Today I want to introduce the price-sales ratio, which works very well for cyclical companies but cannot be used to compare different businesses across different industries.

The P/S ratio is actually very simple. It is the price compared to the sales. So for every one dollar of sales, you want to look at how much you are paying for the stock. If the P/S ratio is two, you are paying two dollars for every one dollar of sales the company makes. Within the same company, a lower P/S ratio is generally better.

For different businesses a lower P/S ratio does not mean lower valuation. So a P/S ratio of one is not necessarily cheaper than a P/S ratio of five.

Looking at Southwest (NYSE:LUV), you will remember that I mentioned that the P/E ratio is wild. Currently the P/S ratio is sitting around 0.8. During the financial crisis of 2008, the P/S ratio was below 0.4. Similar numbers could be seen in 2011, so these were good times to buy Southwest. In 2018, the P/S ratio rose to 3.2 and this would not have been a good time to buy.

Another of my favorite numbers to look at is the price at the median P/S ratio. This gives you a very straightforward chart to look at when considering to buy cyclical companies. As you can see by this line, the median P/S ratio of Southwest has been 1.24. You can see on this line that things stay stable.

When the price is lower than the price at the median P/S ratio line, it is generally a good time to buy. When it is above that line, it is not a good time to buy. Currently due to the price drop of Southwest, the price falls well below this line, so maybe it is a good time to buy for long-term investors.

I hope that you enjoyed this brief look at the P/S ratio. As always, if you have any questions or comments, please leave them below and I will answer them as soon as possible.

See you next time,

Charlie Tian

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About the author:


Charlie Tian, Ph.D., is the founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.