This is Andrew Horowitz with the Winning Investor’s Quick and Dirty Tips for Beating the Market. In this episode I want to explain and expand on a ratio we've discussed previously. Recently, we talked about the P/E ratio which is the current stock Price to reported Earnings Ratio. If you missed that episode you might want to go back and read it or listen to it because today we’ll take the P/E ratio a step further and talk about the PEG Ratio, which adds a whole new dimension to these simple company ratios.
A P/E Ratio Recap
Remember that the P/E ratio is the price to earnings ratio, and you can find it at your favorite financial website or calculate it yourself by taking the company's current stock price and dividing it by the earnings per share or the EPS number. Finding the P/E ratio allows you to compare different stocks to see how relatively expensive or cheap they really are in comparison to other stocks in a similar industry or sector -- in essence; it’s comparing Apples to Apples.
The PEG ratio is similar and might even be more important, because we're not looking at a static number like last month's earnings, but we're trying to forecast earnings into the future for a better assessment of what a stock's price might really be worth and if it is truly more expensive or cheaper than its company peers.
What is the PEG Ratio?
If you can find the PE ratio, you'll have no trouble at all adding one more component to find the PEG ratio -- it's easy.
Instead of just looking at two things -- like the PE Ratio -- we're going to add estimates of growth into the picture now. We're going to do the same calculation for the PE Ratio -- take the current stock price and divide by the reported earnings per share -- and then we're going to add in the growth rate of the company's earnings. We want to know if a company has been increasing in earnings (which is a great thing!), or decreasing in earnings (which isn't so good), or if they're stagnating. Hey, zero growth is better than negative growth after all, but you really want to invest in companies whose earnings are growing month over month and quarter over quarter, and of course year over year.
How to Find the PEG Ratio
While the “P” and the “E” in the PEG ratio are set in stone the growth part isn't. To get that number, you'll often want to look at the analysts' consensus number as found in Yahoo Finance or any other good online website that has a good financial component and you look at a consensus growth number, perhaps over the next five years or so. You can also calculate your own percentage that you feel a company's earnings will grow but I recommend sticking with what the analysts' and what they say. After all, in most cases, they know exactly what they're doing and they’ve been doing it a long time. It’s much more difficult to estimate in the future if you really don’t know all the details.
So you’re taking the standard PE ratio and then dividing by this magic earnings growth number, which might be 10%, 11%, 5%, 3% or some other percentage. So for example, some companies that have great prospects in the future for earnings are going to have a much greater growth rate. In particular you have smaller and newer companies that have better growth rates than the more established blue chips.
What the PEG Ratio Means
If your PEG Ratio winds up to be exactly 1, then this means you have a fairly valued company and that the stock price is most likely trading at fair value-- which is helpful in a sense-- but not what we're looking for in order to make money in the long run.
Now if your PEG Ratio is above 1, then that tells you that you probably have an overvalued company and that the stock price might be too high to support the future price growth. Many analysts suggest avoiding stocks with PEG Ratios that are just too high when compared to others and look out for companies that have a PEG Ratio of above 2.
Finally, if the PEG ratio is less than 1 but greater than zero, that’s the “sweet spot”. That’s the number you want to see, because it means you might have found a company that’s stock price is undervalued relative to the earnings and earnings growth rates. That means that buying this stock could give you a better chance of getting a stock that is undervalued, which means that you could potentially sell it later for a profit when it returns to fair value or goes higher than fair value.
Shortcomings
If all this seems really too easy, know that it is; you'll have to look at many different factors than just the P/E ratio or the PEG ratio to select a basket of successful stocks from a world of thousands and thousands of stocks for your portfolio.
The main shortcoming of the PEG Ratio is that earnings growth -- while important -- is NOT the only factor the market cares about. The market also wants to know about revenue growth, cash flow, dividends, debt, and many other factors that a simple ratio just can't tell you.
Also remember that analysts make assumptions about the future when they calculate the earnings growth estimates, so if something happens, or their assumptions are wrong, then the PEG Ratio you have will also be wrong. Yogi Berra once said "Prediction is difficult, especially about the future" and that is so true when doing financial analysis like this.
Another thing to be cautious about is that newer, smaller companies will often have very high earnings growth projections because they will be expanding quickly into new markets. However, larger, more established companies like Wal-Mart, Clorox, General Electric and other popular "blue chips" will certainly have lower earnings growth projections than companies that have only been around for a few years. That’s also a factor you need to consider when comparing companies. You need to compare companies that are very similar to each other to make distinctions when looking at any type of ratio, we’ve talked about that before, no matter how useful the ratio might be.
Now that you know one more Quick and Dirty Tip for comparing stocks you're one step closer to becoming the Winning Investor you want to be!
And by the way, if there a question you’d really like to ask me and maybe have it appear on our show? Just email me at winninginvestor@quickanddirtytips.com or you can call 206-338-0836. That’s 206-338-0836 and maybe your question will appear. So if you have a question you’ve been thinking about for a long time that you want us to answer on The Winning Investor just email it in or give a call.
This is Andrew Horowitz with the Quick and Dirty Tips for the Winning Investor. Talk to you soon.
