Price-To-Sales Ratio Vs. Price-To-Earnings Ratio: What’s The Difference?

When investors talk about whether a company is “expensive” or “cheap”, they’re usually talking about its valuation. And that makes a lot of sense, at first glance – after all, a company’s valuation is pretty much about how much it’s worth, right?

Well, the challenge is that there isn’t just one way to value a company. In fact, investors use a range of different metrics depending on the type of business they’re looking at and the stage it’s at.

Two of the most common are the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. Both methods are designed to help investors understand how a company’s valuation compares to its financial performance, but they measure very different things. Thus, it’s very possible for companies to receive varying valuations from different authorities and when evaluated by means of different methods.

Now, if you’re somebody who follows big businesses and potential IPOs, you’ve most likely seen both terms used. However, properly understanding these methods will make it significantly easier to follow these conversations surrounding different valuations and why they come up with the numbers that they do.

What Is The Price-To-Sales Ratio?

The price-to-sales ratio compares a company’s market value to its revenue.

The formula for the calculation is quite simple:

Price-to-sales ratio = Market capitalisation ÷ Annual revenue

Alternatively, it could also be calculated on a per-share basis, and to do that, you’d divide the share price by revenue per share.

The ratio tells investors how much they’re paying for every pound, dollar or euro of revenue the company generates.

So for instance, if a company is worth £10 billion and it generates £1 billion in annual revenue, it would have a P/S ratio of 10. In other words, investors are willing to pay £10 for every £1 of revenue the company produces.

According to Investopedia, the P/S ratio is particularly useful when analysing companies that perhaps aren’t yet profitable because it focuses on revenue rather than earnings.

What Is The Price-To-Earnings Ratio?

The price-to-earnings ratio takes quite a different approach. Instead of comparing valuation to revenue, it compares valuation to profit.

The formula is:

Price-to-earnings ratio = Share price ÷ Earnings per share

If you prefer, you can can also be calculate it by dividing market capitalisation by net earnings.

The P/E ratio shows how much investors are willing to pay for each unit of profit a company generates.

For example, if a company’s shares trade at £50 and it earns £5 per share, its P/E ratio would be 10. Basically, investors are paying £10 for every £1 of earnings.

Because it focuses on profit, the P/E ratio is one of the most commonly used valuation metrics for businesses that are more established.

Why Do Tech Investors Often Focus On Price-To-Sales?

One reason the P/S ratio appears so frequently in tech valuation discussions is that many high-growth companies tend to prioritise expansion over profitability.

A startup might be generating hundreds of millions in revenue while they’re spending heavily on hiring, research, infrastructure and customer acquisition. So as result, it may have little profit or even significant losses.

In those situations, a P/E ratio can become difficult or impossible to use because there are no meaningful earnings to measure.

This is why investors have historically looked at price-to-sales ratios when evaluating fast-growing software companies, AI firms and venture-backed startups. Ultimately, the idea is that revenue can provide a clearer picture of growth even when profits remain elusive.

Does That Mean the P/E Ratio Is Better?

One isn’t necessarily inherently better than the other; they both have strengths and weaknesses and it all depends on the business and the context.

On the one hand, the P/E ratio incorporates profitability, which means it can provide a more complete picture of a company’s financial performance. After all, generating revenue is important, but turning that revenue into profit is ultimately what many investors care about.

The downside, however, is that earnings can fluctuate significantly from year to year. A one-off expense, tax charge or accounting adjustment can make profits appear much higher or lower than usual.

Meanwhile, the P/S ratio avoids some of those issues, but in the process, it introduces another problem which is that revenue alone doesn’t tell you whether a company is making money.

So, two businesses might generate exactly the same sales, but if one has strong profit margins and the other loses money on every sale, they are very different businesses.

Which Metric Matters More?

It normally depends on the company in question. For businesses that are more mature and have stable profits, investors often pay close attention to the P/E ratio because earnings provide a clear indication of financial performance.

But for earlier-stage companies, high-growth technology firms and businesses that are investing heavily in expansion, the P/S ratio is often more useful because it focuses on revenue rather than profitability.

The reality of valuations is that investors don’t rely on a single metric. They use both ratios alongside other measures like revenue growth, profit margins, cash flow and debt levels.

Ultimately, neither the P/E nor the P/S ratio is enough entirely on its own, they simply answer the question in a slightly different way.

The price-to-sales ratio helps answer how much investors are paying for this company’s revenue, while the price-to-earnings ratio is asking how much investors are paying for the company’s profits.