Adjusted price to sales

What Is Adjusted Price to Sales?

Adjusted Price to Sales is a refined financial valuation metric that builds upon the traditional price-to-sales (P/S) ratio, aiming to provide a more nuanced assessment of a company's market value relative to its revenue. Unlike the basic P/S ratio, which simply divides a company's market capitalization by its total sales, the Adjusted Price to Sales incorporates qualitative and quantitative adjustments to the sales figure or other financial elements. These adjustments seek to account for factors such as differing revenue recognition policies, variations in gross profit margins, the impact of non-recurring sales, or the quality and sustainability of a company's revenue streams. Within the broader category of financial valuation and investment metrics, the Adjusted Price to Sales serves as a tool for investors and analysts to compare companies more accurately, particularly those with unique business models or accounting practices. This adjusted metric offers a deeper insight into how much investors are truly paying for a company's core, recurring sales.

History and Origin

The concept of a price-to-sales ratio was popularized by Kenneth L. Fisher in the 1980s, who recognized its utility for valuing companies, especially those with little or no earnings. Fisher observed that while earnings can fluctuate significantly, a company's sales tend to be more stable and less prone to accounting manipulations than net income.¹⁰ Over time, as financial analysis evolved, it became apparent that even sales figures, while robust, could benefit from adjustments to provide a more accurate picture. The need for an Adjusted Price to Sales metric arose from the limitations of the raw P/S ratio, particularly its failure to consider profitability, debt levels, or the quality of revenue. Academic research, such as studies on "modified price-sales ratios" incorporating factors like profitability and long-term debt, have contributed to the development and acceptance of such adjustments, aiming to create a more useful tool for investors.⁹ This continuous refinement reflects the ongoing effort in investment analysis to gain a clearer understanding of a company's underlying value.

Key Takeaways

• Adjusted Price to Sales refines the traditional price-to-sales ratio by accounting for specific qualitative and quantitative factors.
• It provides a more accurate valuation perspective, particularly for companies with varying revenue recognition methods, non-recurring sales, or diverse profit margins.
• Adjustments can involve normalizing revenue for extraordinary items, considering the sustainability of sales, or integrating profitability insights.
• This metric is especially useful for valuing high-growth companies or those with inconsistent earnings, where traditional earnings-based multiples may not be applicable.
• Interpreting the Adjusted Price to Sales requires industry-specific context and a comprehensive understanding of a company's business model.

Formula and Calculation

The Adjusted Price to Sales is not governed by a single, universally accepted formula but rather represents a conceptual modification of the basic Price-to-Sales Ratio. The core idea is to modify the revenue component to better reflect the sustainable and qualitative aspects of a company's sales.

The general approach is:

Alternatively, on a per-share basis:

Where:

• Market Capitalization is the current market value of a company's outstanding shares.
• Stock Price is the current price of a single share.
• Adjusted Total Sales (or Adjusted Sales Per Share) is the company's total revenue (or sales per share) after applying specific modifications. These modifications might include:
  • Normalizing for non-recurring items: Removing or adjusting for one-time sales events that are unlikely to repeat.
  • Accounting for revenue recognition differences: Adapting reported sales based on different accounting standards or practices (e.g., for "bill-and-hold" arrangements, as discussed by the SEC).⁸
  • Considering sales quality/sustainability: Factoring in the predictability or recurring nature of sales.
  • Implicitly or explicitly integrating profitability: Some "modified" ratios might use a sales figure that has been adjusted for average gross profit margins within an industry or for a company's historical profitability.

Analysts apply these adjustments based on their understanding of the company's business model and the nuances within its income statement.

Interpreting the Adjusted Price to Sales

Interpreting the Adjusted Price to Sales involves assessing the derived ratio in the context of the company's industry, business model, and competitive landscape. A lower Adjusted Price to Sales ratio generally suggests that a company's stock may be undervalued relative to its sales, after accounting for specific quality factors. Conversely, a higher ratio might indicate overvaluation. However, these interpretations are highly contextual. For instance, high-growth companies, particularly in sectors like technology or software, often command higher Adjusted Price to Sales ratios due to anticipated future revenue growth and potentially higher long-term profit margins, even if current sales are modest.⁷

When evaluating this metric, it is crucial to compare a company's Adjusted Price to Sales to its historical values and to the Adjusted Price to Sales of its peers within the same industry. Comparing companies across different sectors using raw P/S ratios can be misleading due to varying business models and inherent profit margins.⁶ The "adjusted" aspect aims to make cross-company comparisons within an industry more meaningful by leveling the playing field for revenue quality. Understanding the specific adjustments made is essential for accurate interpretation, as these adjustments directly influence the perceived value derived from the sales figures.

Hypothetical Example

Consider two hypothetical software-as-a-service (SaaS) companies, "TechSolutions Inc." and "InnovateNow Corp.," both reporting $100 million in annual revenue and having a market capitalization of $500 million. A simple Price to Sales Ratio for both would be 5 ($500M / $100M).

However, upon deeper investment analysis:

• TechSolutions Inc. includes $20 million in revenue from a one-time software license deal with a government agency that is highly unlikely to recur in the next fiscal year. Its gross profit margin is consistently 70%.
• InnovateNow Corp. derives all its $100 million revenue from recurring subscription fees. Its gross profit margin is slightly lower at 65%, but its revenue growth is highly predictable.

To calculate an Adjusted Price to Sales, an analyst might:

1. Adjust TechSolutions' Sales: Subtract the non-recurring revenue.
   Adjusted Sales for TechSolutions = $100 million - $20 million = $80 million.
   Adjusted Price to Sales for TechSolutions = $500 million / $80 million = 6.25.

2. InnovateNow's Sales: No significant non-recurring revenue, so its reported sales are stable. In this case, no adjustment for recurring revenue quality is needed.
   Adjusted Price to Sales for InnovateNow = $500 million / $100 million = 5.00.

In this hypothetical example, even though both companies had the same initial Price to Sales ratio, the Adjusted Price to Sales reveals a different picture. TechSolutions, after adjusting for the non-recurring revenue, appears "more expensive" relative to its sustainable sales base (6.25 vs. 5.00), suggesting that InnovateNow might offer a more attractive valuation multiple based on its recurring revenue model. This highlights how considering the quality of sales can influence valuation.

Practical Applications

The Adjusted Price to Sales ratio finds practical application in several areas of finance and investment:

1. Early-Stage and High-Growth Company Valuation: For startups or rapidly expanding companies, profitability may be low or non-existent, making earnings per share (EPS) or price-to-earnings (P/E) ratios less useful for valuation.⁵ The Adjusted Price to Sales offers a more relevant metric by focusing on revenue, while also addressing its quality or sustainability. This is particularly relevant in sectors where companies prioritize market share and revenue growth over immediate profitability.
2. Cross-Industry Comparisons with Nuances: While raw Price to Sales ratios are best used within the same industry, Adjusted Price to Sales can help bridge minor industry-specific revenue recognition or business model differences that impact revenue quality. For example, comparing a traditional software company to a SaaS provider requires understanding the recurring nature of revenue, which an adjustment can reflect.
3. Mergers and Acquisitions (M&A): In M&A deals, buyers often scrutinize the quality of a target company's revenue streams. An Adjusted Price to Sales metric can help acquirers understand the sustainable revenue base they are purchasing, beyond just reported top-line figures. This helps in determining a fair acquisition price and assessing the potential for future financial health.
4. Assessing Revenue Quality: The process of calculating Adjusted Price to Sales forces analysts to delve into the details of a company's revenue recognition policies, contract structures, and the breakdown of its sales. This deep dive can uncover important insights into the consistency and reliability of a company's sales, which might not be evident from a superficial review of its income statement. The U.S. Securities and Exchange Commission (SEC) provides extensive guidance on revenue recognition, highlighting the complexities involved and the need for careful analysis of how companies report their sales.⁴

Limitations and Criticisms

While the Adjusted Price to Sales aims to improve upon the basic Price to Sales Ratio, it is not without its limitations and criticisms.

First, the primary drawback, similar to the unadjusted P/S ratio, is that it still does not directly account for a company's profitability or cost structure.³ A company might generate substantial adjusted sales, but if its operating expenses are excessively high or its profit margins are consistently low, these sales may not translate into meaningful earnings or cash flow for shareholders.² This fundamental disconnect means that even with adjustments, the metric should not be used in isolation for making investment decisions. Investors should consider a company's ability to convert sales into profit.

Second, the "adjustment" itself can be subjective. There is no standardized method for calculating Adjusted Price to Sales, meaning different analysts might apply different adjustments based on their interpretations of revenue quality or accounting nuances. This lack of standardization can make direct comparisons of "adjusted" ratios across different analyses challenging.

Third, the Adjusted Price to Sales may still not fully capture a company's debt load or the overall strength of its balance sheet. A company with a seemingly attractive Adjusted Price to Sales could be highly leveraged, posing significant financial risk. The presence of substantial debt means a company will have higher interest expenses, which drain profits even if sales are strong.

Finally, while the Adjusted Price to Sales attempts to normalize for revenue quality, it may not adequately reflect all qualitative factors, such as brand strength, competitive advantages, or management quality. These intangible assets can significantly influence a company's long-term growth prospects and overall valuation, but they are not directly quantifiable within a sales-based multiple.¹ Therefore, relying solely on an Adjusted Price to Sales ratio for valuation can be a false indicator of value if other crucial financial ratios and qualitative aspects are ignored.

Adjusted Price to Sales vs. Price-to-Sales Ratio

The distinction between Adjusted Price to Sales and the Price-to-Sales Ratio (P/S Ratio) lies in the level of detail and refinement applied to the revenue component.

While the Price-to-Sales Ratio offers a foundational metric for valuing companies, particularly those without positive earnings, the Adjusted Price to Sales seeks to enhance its accuracy by considering qualitative aspects that influence the quality and consistency of a company's sales. The "adjusted" variant recognizes that not all sales dollars are created equal, and a more robust financial analysis requires distinguishing between high-quality, sustainable revenue and less predictable streams.

FAQs

Why is an "adjusted" price to sales ratio needed?

An Adjusted Price to Sales ratio is needed because the raw Price-to-Sales Ratio can sometimes present a misleading picture of a company's valuation. Sales figures can be influenced by non-recurring events, aggressive revenue recognition policies, or significant differences in profitability across business lines. Adjusting the sales figure aims to normalize these factors, providing a more accurate and comparable measure of a company's market value relative to its sustainable revenue.

What kind of adjustments are typically made?

Adjustments can vary but often include removing non-recurring revenue (e.g., from one-time asset sales), accounting for variations in revenue recognition practices, or normalizing for unusual sales spikes or drops. Some sophisticated adjustments might also implicitly or explicitly consider a company's typical profit margins or the recurring nature of its sales to arrive at a "quality-adjusted" sales figure.

Is Adjusted Price to Sales better than Price-to-Earnings (P/E) Ratio?

Neither is inherently "better"; they serve different purposes. The P/E ratio focuses on a company's profitability, showing how much investors are willing to pay for each dollar of earnings. The Adjusted Price to Sales focuses on revenue. The Adjusted Price to Sales is particularly useful when a company has negative earnings or highly volatile earnings, making the P/E ratio inapplicable or unreliable. However, for companies with consistent profitability, the P/E ratio remains a crucial valuation multiple. It is often recommended to use both in conjunction for a comprehensive financial analysis.

Can Adjusted Price to Sales be used for all industries?

Yes, the concept of Adjusted Price to Sales can be applied across various industries, but the specific types of adjustments made will differ. For instance, in real estate, adjustments might focus on recognizing revenue from property sales versus rental income, while in manufacturing, it might involve accounting for different contract types. The key is to understand the industry's specific revenue drivers and accounting standards to apply relevant adjustments.

Does Adjusted Price to Sales consider a company's debt?

Generally, the calculation of Adjusted Price to Sales does not directly incorporate a company's debt levels. It primarily focuses on refining the revenue component. While a low Adjusted Price to Sales might suggest an undervalued company, it does not tell the whole story if that company carries a heavy debt burden. For a more comprehensive valuation that includes debt, the Enterprise Value (EV) to Sales ratio or a Discounted Cash Flow (DCF) model might be more appropriate.