Unpleasant Surprises Could Be In Store For Xero Limited's (ASX:XRO) Shares

When you see that almost half of the companies in the Software industry in Australia have price-to-sales ratios (or "P/S") below 3x, Xero Limited (ASX:XRO) looks to be giving off strong sell signals with its 14.9x P/S ratio. Although, it's not wise to just take the P/S at face value as there may be an explanation why it's so lofty.

See our latest analysis for Xero

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

Xero's revenue growth of late has been pretty similar to most other companies. One possibility is that the P/S ratio is high because investors think this modest revenue performance will accelerate. However, if this isn't the case, investors might get caught out paying too much for the stock.

Want the full picture on analyst estimates for the company? Then our free report on Xero will help you uncover what's on the horizon.

How Is Xero's Revenue Growth Trending?

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 24%. The latest three year period has also seen an excellent 102% overall rise in revenue, aided by its short-term performance. Accordingly, shareholders would have definitely welcomed those medium-term rates of revenue growth.

Turning to the outlook, the next three years should generate growth of 17% each year as estimated by the analysts watching the company. That's shaping up to be materially lower than the 20% per annum growth forecast for the broader industry.

With this information, we find it concerning that Xero is trading at a P/S higher than the industry. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. Only the boldest would assume these prices are sustainable as this level of revenue growth is likely to weigh heavily on the share price eventually.

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

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. At these price levels, investors should remain cautious, particularly if things don't improve.

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.

If you're unsure about the strength of Xero's business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.

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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.