With a price-to-sales (or "P/S") ratio of 9x Workday, Inc. (NASDAQ:WDAY) may be sending very bearish signals at the moment, given that almost half of all the Software companies in the United States have P/S ratios under 4.4x and even P/S lower than 1.7x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly elevated P/S.

What Does Workday's Recent Performance Look Like?

There hasn't been much to differentiate Workday'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. If not, then existing shareholders may be a little nervous about the viability of the share price.

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

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

Taking a look back first, we see that the company grew revenue by an impressive 17% last year. The latest three year period has also seen an excellent 68% overall rise in revenue, aided by its short-term performance. Therefore, it's fair to say the revenue growth recently has been superb for the company.

Shifting to the future, estimates from the analysts covering the company suggest revenue should grow by 17% per annum over the next three years. That's shaping up to be similar to the 15% each year growth forecast for the broader industry.

In light of this, it's curious that Workday's P/S sits above the majority of other companies. It seems most investors are ignoring the fairly average growth expectations and are willing to pay up for exposure to the stock. Although, additional gains will be difficult to achieve as this level of revenue growth is likely to weigh down the share price eventually.

The Key Takeaway

Typically, we'd caution against reading too much into price-to-sales ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.

Analysts are forecasting Workday's revenues to only grow on par with the rest of the industry, which has lead to the high P/S ratio being unexpected. The fact that the revenue figures aren't setting the world alight has us doubtful that the company's elevated P/S can be sustainable for the long term. A positive change is needed in order to justify the current price-to-sales ratio.

A lot of potential risks can sit within a company's balance sheet. You can assess many of the main risks through our free balance sheet analysis for Workday with six simple checks.

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.