Understanding The PEG Ratio and What Price/Earnings To Growth Means | Exploring Markets

Understanding The PEG Ratio and What Price/Earnings To Growth Means

The PEG ratio is not used enough.

The PE ratio, on the other hand, is used all the time. That's a problem. In this post you are going to learn why you need to start using the PEG ratio more and what it is.

• The PE ratio stands for price divided by earnings.
• The PEG ratio stands for price divided by earnings divided by its growth rate.

The PE Ratio is one of the most popular things people talk about when analyzing stocks. The PE ratio, in its simplest form, tells you how much you are paying to own a stock for every dollar it makes in profit. So if a stock has a PE ratio of 35 and you buy that stock, you are essentially paying $35 to own $1 of profit in that company right now. That sounds like a terrible deal, right? But the PE ratio is flawed.

The problem is that the PE ratio does not factor in future growth. The PEG ratio does. Here's a quick example that should start to show you the power of the PEG ratio.

In the example above, a stock with a PE ratio of 35 sounds like a bad investment. But what if that company is doubling its earnings and growing every year? That's where the PEG ratio becomes a brilliant tool. Take the PE ratio of 35 and divide that by its earnings growth rate. In this example the company is doubling its earnings each year so that is a 100% growth rate. The equation would be 35/100 (use the whole number instead of the percentage) and what does that equal? Try 0.35.

Whoa! The general rule is that a PEG ratio above 1 means a stock could be too expensive and below 1 means a stock could be trading at a discount to its intrinsic value. In this case, the PEG ratio is 0.35. It's trading at a severe discount to its earnings growth rate.

Now do you see the power of the PEG ratio and the disadvantages of the PE ratio?

Here's the final takeaway. The stock market is a future and forward looking machine. The big banks, mutual funds, hedge funds, and Wall Street pros buy stocks based on how they are expected to grow and perform in the future. They don't care about the present or past. The problem is that the PE ratio is a stock's current price divided by its latest earnings per share. That entire formula factors in no growth and no future prospects. But the PEG ratio does. You can see that in its name and formula. Take the PE ratio and divide it by its earnings growth rate. You now have a clear picture at what you are paying for current and future earnings.