Pinning Down Xero Limited's (ASX:XRO) P/S Is Difficult Right Now

When you see that almost half of the companies in the Software industry in Australia have price-to-sales ratios (or "P/S") below 2.8x, Xero Limited (ASX:XRO) looks to be giving off strong sell signals with its 14.5x P/S ratio. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

View our latest analysis for Xero

What Does Xero's Recent Performance Look Like?

There hasn't been much to differentiate Xero's and the industry's revenue growth lately. It might be that many expect the mediocre revenue performance to strengthen positively, which has kept the P/S ratio from falling. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

What Are Revenue Growth Metrics Telling Us About The High P/S?

The only time you'd be truly comfortable seeing a P/S as steep as Xero's is when the company's growth is on track to outshine the industry decidedly.

If we review the last year of revenue growth, the company posted a terrific increase of 23%. The latest three year period has also seen an excellent 95% overall rise in revenue, aided by its short-term performance. So we can start by confirming that the company has done a great job of growing revenue over that time.

Shifting to the future, estimates from the analysts covering the company suggest revenue should grow by 17% each year over the next three years. Meanwhile, the rest of the industry is forecast to expand by 20% per year, which is noticeably more attractive.

With this in consideration, we believe it doesn't make sense that Xero's P/S is outpacing its industry peers. 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.

What We Can Learn From Xero's P/S?

It's argued the price-to-sales ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.

We've concluded that Xero currently trades on a much higher than expected P/S since its forecast growth is lower than the wider industry. 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. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.

Many other vital risk factors can be found on the company's balance sheet. Our free balance sheet analysis for Xero with six simple checks will allow you to discover any risks that could be an issue.

It's important to make sure you look for a great company, not just the first idea you come across. So if growing profitability aligns with your idea of a great company, take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).

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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.