Using the PEG Ratio in Your Investment Analysis

If you aren't already using the PEG ratio in your investment analysis, it may be time to start. You can use this valuation metric to supplement other measures, such as price-to-earnings (or P/E) and price-to-book value per share, to help you identify undervalued stocks.

What is the PEG Ratio?

The PEG ratio is simply a stock's P/E ratio divided by a company's projected earnings growth rate. Most often, a stock with a PEG ratio of less that 1 is considered a good value on this measure.

Advantages of the PEG Ratio

The PEG ratio has a number of advantages for stock analysis.

First, it is easy to calculate. Also the numbers needed to arrive at a public company's PEG ratio often are readily available in the stock statistics at such websites as Yahoo Finance.

Second, it is straightforward and simple to understand. A stock with a PEG ratio of 1 is trading at a P/E ratio in line with its projected growth rate. If its P/E ratio stays the same and it achieves its earnings growth goals, its share price will increase in line with its earnings growth.

Third, it takes growth as well as earnings into account, providing a more comprehensive valuation metric than the P/E ratio alone. A stock's P/E reflects what investors are willing to pay for $1 of earnings. If a company earns $1 per share and trades at 12 times earnings, investors are willing to pay $12 for each $1 of earnings. However, a rational investor might value the earnings differently depending on how fast he expects them to grow over the next three to five years. Logically, a company with $1 per share of earnings that will grow 20% annually is worth more than one with $1 per share of earnings and 5% future earnings growth. The former might be undervalued at 15 times earnings per share while the latter may be overvalued at 10 times earnings per share. Using the PEG ratio helps investors identify these differences and take them into account in their investment decisions.

Disadvantages of the PEG Ratio

Like all stock valuation metrics, the PEG ratio has its disadvantages.

For one thing, it is dependent on the accuracy of projections for both earnings and for earnings growth. If either of these estimates is wrong, the usefulness of the PEG ratio will be negatively affected.

Also, the PEG ratio only takes earnings and earnings growth into account in valuing a stock. It does not take into account other factors that may affect a stock's worth, such as a company's financial condition and asset values and the economic and regulatory environments, to name just a few.

While the PEG ratio is not perfect, it can be a valuable tool to use in your investment analysis, especially if used in combination with other valuation metrics and fundamental research. Also, it can be useful for screening stocks, for example, if you want to invest in companies in a specific industry and would like to identify stocks in that sector that appear to have the best prospects.

Source:

Joseph Khattab, www.fool.com, How Useful Is the PEG Ratio?