A stock's
price/earnings ratio divided by its year-over-year earnings growth rate.
PEG is an accurate and widely used indicator of a stock's potential
value.
For as long as I can remember, investors have used the Price-Earnings
Ratio (P/E Ratio)
to determine if a company is over or under valued. The problem we have with this
ratio is there are many extreme cases of stocks trading at 10,000 or more times
their earnings. (These are typically start-up companies with little or no
revenues). Just because a company has a high P/E ratio does not mean it could
not be a good buy for the long term.
We have two components here, the market value (price) of the stock and the earnings
of the company.
Earnings are very important to consider. After all, earnings represent profits
which are the core of what every business strives for. Earnings take into
account the hard figures such as: revenue, cost
of goods sold (COGS), salaries, rent, etc.. These are all important to the
livelihood of a company. If the company isn't using it's resources effectively
it will not have positive earnings and there will be problems eventually.
Besides earnings, there are other factors which affect the value of a stock. For
example:
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Brand
- The name of a product or company has value. Brands such as McDonalds,
Microsoft and General Motors are worth billions.
·
Expertise
- Now more than ever, A company's employees and their expertise are
thought to add value to the company. It's about time!
·
Expectations
- The stock market is forward looking. You buy a stock because of high
expectations of strong profits or a new technology, not because of
something they did several months ago.
·
Distribution
Channels - The
method that a company uses to get a product to its customers. For
example, Coca-Cola owns many of its channels, while Pepsi is forced to
use existing ones where it often runs into union problems.
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All these factors will
affect a company's rate of growth. The P/E ratio does not take into account any
of this and instead only looks at what has been done in the past.
The relationship between the price/earnings ratio and earnings growth tells a
much more complete story than the P/E on its own. The PEG Ratio is defined as:
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PEG
Ratio =
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Price/Earnings
Ratio
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Annual
Growth Rate*
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* The number used for
annual growth rate can vary. For example, it can be either forward (predicted
growth) or trailing and either a 1 or 5 year time span. Check with the source
providing the PEG ratio to see what number they use.
Comparing the PEG of
companies is the same as if it were the P/E ratio. A lower PEG means that the
stock is more undervalued.
Let's demonstrate the PEG ratio with an example: You are interested in buying
stock in one of two companies. The first is a networking company with 50% annual
growth in net income and a P/E Ratio of
100. The second company is in the beer business. It has lower earnings growth at
24% and it's P/E ratio is also relatively low at 12.
Many justify the valuations of tech companies by saying they have enormous
growth potential. Is this the case in our example?
Networking Company:
P/E ratio (100) divided by the annual earnings growth rate (50) = PEG ratio of 2
Beer Company:
P/E ratio (12) divided by the annual earnings growth rate (24) = PEG ratio of .5
The PEG ratio shows us the sexier high-tech company doesn't have the growth rate
to justify it's P/E relative to the beer company.
Take Microsoft as another example. At time of writing it had a P/E of 37 and an
expected earnings growth next year of 9.6%, this gives us a PEG 3.86. The S&P
500 has a P/E of 24 and an earnings growth of 14%, this produces a PEG of
1.71. Judging by the PEG ratio, Microsoft is significantly pricier than the
S&P 500.
Investors are getting more picky. Many have abandoned the P/E ratio not because
it is worthless, but because we desire more information about a stocks potential
before investing. We've realized that the P/E doesn't tell us a whole lot.
Instead, using the P/E along with current growth rates can produce the more
useful PEG ratio, a great indicator of a stock's potential value.
