Best Guide on Leveraging P/S Ratio in Growth Investing Strategy of the Quant Trading

In this article, I would like to share one of the most popular buying signal metrics in the growth investing strategy of the quant trading, which is the P/S ratio, or price-to-sales ratio. By the end of this article, you will learn what P/S is, the benefits of P/S, how it works in quant trading, and things that you need to be cautious of when you are taking it into account to detect potential buying signals from thousands of stock tickers.

To whom:

• People who are beginners in quant trading
• People who are using AI to analyze potential investment opportunities

Table of Contents: Best Guide on Leveraging P/S Ratio in Growth Investing Strategy of the Quant Trading

• What is the P/S ratio
• Why using the P/S ratio is a great choice in opportunity detection
• How to use the P/S ratio in quant trading
• P/S Ratio Limitation
• AI Prompt Components to analyse investment opportunities using the P/S ratio
• AI Prompt sample and growth investing strategy python script

What is the P/S ratio?

Basically, P/S or price-to-sales ratio metric measures how much investors are willing to pay for each dollar of a company’s revenue or sales. Based on the following formula, a company has market cap US$1 billion with historical average annual revenue or trailing annual revenue US$200 million, the P/S ratio is 5, which implies investors are willing to pay for 5 dollars for every single dollar of sales from this company.

P/S Ratio = Market capitalization / total revenue. Or P/S ratio = Share price / revenue per share

Why using the P/S ratio is a great choice in opportunity detection

P/S ratio is used for evaluating unprofitable growth companies where P/E is not useful. It more emphasises the growth momemtum and calculate, predict the future growth potential. Particularly, it’s an effective and powerful strategy to quantify the opportunities out of mainstream radar which most of companies are profitable, and collect those companies at early stages with strong momentum of growth. It’s a great choice to collect a list of potential tickers which can give you a chance to buy from low position, and get capital gains by selling them in a higher position in the future.

Furthremore, P/S ratio requires investors having an anchoring and comparison point of view to justify the opportunities, because higher or lower P/S is not an absolute answer to judge the stock ticker is potential or not. So if you have some peers from a fast and potential growth sectors and industries, P/S ratio is a great weapon for you to network in similar area and substituting area, which may be affected by the mainstream growth area.

How to use the P/S ratio in quant trading

In general, except for varying widely by sectors, P/S ratio basically correlates to the company revenue and earning growth, meanwhile it can not reflect the company profitability. So based on these two essential characteristics, here is the baseline formula to detect if there are any potential investment opportunities, where the companies have these kind of growth performance

P/S ratio <10 and revenue growth rate >0.1 and earning growth rate >0.1

Advanced line by considering the essential characteristics of P/S ratio and factoring in more aspects to narrow down the options from the opportunities and increase the right potential opportunity rate as follows:

• PEGPS < 1. PEGPS = P/S / revenue growth rate
• gross margin > 0.4 and free cash flow > 0
• operating margin > 0.1

P/S Ratio Limitation

P/S ratio is a metric that can not work standalone as the ratio result, which is higher or lower, can not indeed imply any valuable information. For example, P/S varies by sectors. P/S ratio 10 is acceptable in tech sector, which is not attractive in grocery and retal sector. Also, higher P/S ratio without positive certain amount of growth rate mean nothing. Also, declining revenue or margins can cause P/S ratio losing its reference value. Lastly, aggressive accounting for revenue can imply the problems of quality of sales as well. So as you can see, P/S ratio limitation is that investors can not only look at its performance

Although lower P/S ratio normally represents a better chance, it is not the absolute answer as well. For example, a company has 30% - 100% growth with P/S ratio 15, which its peer stays around 12 - 20, is still acceptable. And then, the company has super high margin which is 70 - 90%, such as SaaS etc, P/S ratio which is higher than 10 is totally acceptable. More importantly, if the market sentiment and investors believe in the company future growth and are willing to pay for it even though it’s not profitable, higher P/S ratio is also a signal of potential opportunity

AI Prompt Components to analyse investment opportunities using the P/S ratio

If you use generative AI to analyse investment opportunities, in terms of P/S ratio, here are a list of components you need to consider and include it in the AI prompt as follows:

• Market and exchange that the company belongs to
• Company sector, industry
• revenue, gross margin, operating margin,earnings from income statement
• free cashflow
• TTM P/S ratio (can use yahoo finance or other 3rd party API to fetch the trailing value)
• Peer companies in similar area and substitute area

AI Prompt sample and growth investing strategy python script

def growth_investing(ticker):
    # Fetch financial data and calculate growth metrics
    growth_stocks = []
    revenue_growth = ""
    earnings_growth = ""
    ps_ratio = ""
    # Define growth criteria/threshold (example: Revenue Growth > 10%, Earnings Growth > 10%, P/S < 10)
    if revenue_growth and revenue_growth > 0.10 and earnings_growth and earnings_growth > 0.10 and ps_ratio and ps_ratio < 10:
        growth_stocks.append({
            "Ticker": ticker,
            "Revenue Growth": revenue_growth,
            "Earnings Growth": earnings_growth,
            "P/S Ratio": ps_ratio,
            "Growth_qualification": "Verified"
        })
    else:
        growth_stocks.append({
            "Ticker": ticker,
            "Revenue Growth": revenue_growth,
            "Earnings Growth": earnings_growth,
            "P/S Ratio": ps_ratio,
            "Growth_qualification": "Not Verified"
        })
    return growth_stocks

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