Analyzing Stocks With The PEG Ratio

by : Jim Pretin

The two most important numbers that investment analysts look at when evaluating a stock are the P/E ratio and the PEG ratio. The former has been around for as long as the stock market itself, the latter originated more recently. A thorough analysis of these dueling indicators reveals that one is definitely superior to the other.

The P/E is the price-to-earnings ratio. It is used to calculate how expensive or how cheap a stock is relative to its earnings. Using it, an investor can get a sense of whether a stock might be overvalued or undervalued. The ratio is calculated as follows:

P/E = Price per share / Earnings per share

The price per share is the current market price for a single share of stock. The earnings per share is the net income divided by the total number of shares outstanding. You can find net income by looking at a current income statement, which almost all corporations now make available on their company website.

The lower the P/E, the cheaper the stock is. The higher the ratio, the more expensive the stock is relative to its current earnings. However, that does not give you the full picture. The reason why some companies sometime trade at very high price-to-earnings ratios is because they are expected to grow tremendously in the months and years ahead. So, investors are willing to pay more than what the company is currently worth because they feel the company will be worth a lot more in the future.

So, you should not necessarily run away from a company with a high P/E. In fact, those companies are sometimes the best investments, because if their earnings climb tremendously, then the stock will pay a large dividend in the future (for the uninitiated, dividends are a percentage of the profits of a company that are distributed to its shareholders). So, a high P/E ratio can be a very good thing or a very bad thing.

As with a high P/E, a low P/E can also be tricky. If it is low, this could be an indication that the earnings of the company are expected to plummet, causing investors to run away from the stock, resulting in a low share price.

Or, the low ratio might indicate that the company is currently undervalued, making it a good buy because as long as the company is expected to have stable earnings growth in the future, then the share price will go up. It is not easy to discern whether a high or low ratio is good or bad; you need to take into account the expectations for future earnings growth to understand if the P/E ratio is a positive or a negative.

The pitfalls of using the P/E ratio to interpret the relative worth of a stock resulted in analysts coming up with a better measurement, which is known as the PEG ratio. The PEG refers to the price-to-earnings growth ratio. It is calculated like this:

PEG = (P/E) / Annual earnings-per-share growth

The lower the PEG ratio, the more undervalued the company is. A PEG ratio of 1 or less is considered excellent. For example, if a company has a P/E ratio of 30, and annual earnings-per-share growth of 50%, then the PEG would be 0.6, making this company an excellent buy because it is undervalued and the stock price will almost definitely climb. However, if a company has a PEG of 1.5, that means that the stock price is high relative to the earnings growth, which means that unless the company is supposed to grow at a faster rate in the years head, the stock price might not hold up.

So, it is obvious that the PEG is a much more valuable tool for investors to use. It reveals whether the high price of a stock is justified based on whether earnings will grow enough to continue to drive the stock higher.

The P/E falls short in this regard because it does not take into account by what percentage earnings are growing each year. Increasing earnings are the driving force behind an increase in the price of a stock. Therefore, using the PEG, you can truly ascertain whether the price is currently too high and whether it is a good time to buy the stock.

I hope this information has helped you form an understanding of how to evaluate stock prices. Try to set aside some money for investing, and begin to analyze stocks and buy the ones that have a low PEG. They may not go up right away, but in the long run they should increase significantly, unless there is something fundamentally wrong with the company. Research carefully the companies you are going to invest in and you will do fine.