Palo Alto Networks, Inc.'s (NASDAQ:PANW) price-to-sales (or "P/S") ratio of 13x might make it look like a strong sell right now compared to the Software industry in the United States, where around half of the companies have P/S ratios below 4.4x and even P/S below 1.6x are quite common. However, the P/S might be quite high for a reason and it requires further investigation to determine if it's justified.

How Has Palo Alto Networks Performed Recently?

Palo Alto Networks certainly has been doing a good job lately as it's been growing revenue more than most other companies. It seems that many are expecting the strong revenue performance to persist, which has raised the P/S. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.

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

Palo Alto Networks' P/S ratio would be typical for a company that's expected to deliver very strong growth, and importantly, perform much better than the industry.

If we review the last year of revenue growth, the company posted a terrific increase of 20%. The strong recent performance means it was also able to grow revenue by 95% in total over the last three years. So we can start by confirming that the company has done a great job of growing revenue over that time.

Looking ahead now, revenue is anticipated to climb by 17% each year during the coming three years according to the analysts following the company. Meanwhile, the rest of the industry is forecast to expand by 15% each year, which is not materially different.

In light of this, it's curious that Palo Alto Networks' P/S sits above the majority of other companies. Apparently many investors in the company are more bullish than analysts indicate and aren't willing to let go of their stock right now. These shareholders may be setting themselves up for disappointment if the P/S falls to levels more in line with the growth outlook.

The Bottom Line On Palo Alto Networks' P/S

While the price-to-sales ratio shouldn't be the defining factor in whether you buy a stock or not, it's quite a capable barometer of revenue expectations.

Given Palo Alto Networks' future revenue forecasts are in line with the wider industry, the fact that it trades at an elevated P/S is somewhat surprising. Right now we are uncomfortable with the relatively high share price as the predicted future revenues aren't likely to support such positive sentiment for long. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.

It is also worth noting that we have found 2 warning signs for Palo Alto Networks (1 makes us a bit uncomfortable!) that you need to take into consideration.

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.