Getting In Cheap On Xero Limited (ASX:XRO) Is Unlikely

You may think that with a price-to-sales (or "P/S") ratio of 13.4x Xero Limited (ASX:XRO) is a stock to avoid completely, seeing as almost half of all the Software companies in Australia have P/S ratios under 4.1x and even P/S lower than 1.6x aren't out of the ordinary. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

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View our latest analysis for Xero

What Does Xero's P/S Mean For Shareholders?

With revenue growth that's superior to most other companies of late, Xero has been doing relatively well. The P/S is probably high because investors think this strong revenue performance will continue. If not, then existing shareholders might be a little nervous about the viability of the share price.

If you'd like to see what analysts are forecasting going forward, you should check out our free report on Xero.

Is There Enough Revenue Growth Forecasted For Xero?

In order to justify its P/S ratio, Xero would need to produce outstanding growth that's well in excess of the industry.

Retrospectively, the last year delivered an exceptional 23% gain to the company's top line. The strong recent performance means it was also able to grow revenue by 92% in total over the last three years. Therefore, it's fair to say the revenue growth recently has been superb for the company.

Looking ahead now, revenue is anticipated to climb by 26% per year during the coming three years according to the ten analysts following the company. With the industry predicted to deliver 66% growth each year, the company is positioned for a weaker revenue result.

With this information, we find it concerning that Xero is trading at a P/S higher than the industry. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. There's a good chance these shareholders are setting themselves up for future disappointment if the P/S falls to levels more in line with the growth outlook.

The Key Takeaway

Generally, our preference is to limit the use of the price-to-sales ratio to establishing what the market thinks about the overall health of a company.

It comes as a surprise to see Xero trade at such a high P/S given the revenue forecasts look less than stellar. The weakness in the company's revenue estimate doesn't bode well for the elevated P/S, which could take a fall if the revenue sentiment doesn't improve. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.

A lot of potential risks can sit within a company's balance sheet. Take a look at our free balance sheet analysis for Xero with six simple checks on some of these key factors.

Of course, profitable companies with a history of great earnings growth are generally safer bets. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.