The price-to-sales measures the market value of the company against its annual sales. Investors buy low PSR stocks because they believe companies are undervalued when they are not paying much for the sales the company generates. Also, PSR is a more stable ratio than EY, for example, as sales fluctuate less than earnings, and it can be used to value companies that temporarily have no earnings.
James O'Shaughnessy, in his book, ‘What works on Wall Street’, called the PSR the ‘king of the valuation factors’ as it beat the returns of all the valuation ratios he tested.
James Montier, in his 2008 paper, ‘Joining the dark side: Pirates, Spies and Short Sellers’, on the other hand, used the price-to-sales ratio to find overpriced companies that may be good candidates to sell short. A high PSR allows you to hone in on companies whose valuation has lost all touch with reality.
As you can see, this is a strong factor with linear returns for all three company sizes. However, it is not as effective with small companies as it only beats the market 58% of the time. Returns of Q1 were also not as high as some of the other single factors we tested. This may be because sales do not automatically lead to profits, and thus this ratio may work better in combination with another factor, something we tested in the two-factor strategies.