How the peg ratio can help discover value stocks

When discussing due diligence or stock analysis, the price-to-earnings ratio (PEG) ratio of a stock may not be the first indicator that comes to mind, but most people will agree that the PEG ratio simply provides a more complete stock valuation chart than simply viewing the price-to-earnings ratio ( P/E).

The PEG ratio is easy to calculate and represents the ratio of P/E to the company’s expected future earnings per share (EPS) growth rate.

PEG ratio = price-earnings ratio/EPS growth rate

Key points

  • The PEG ratio measures the ratio of a stock’s price-to-earnings ratio to growth, and may be a useful tool when studying value stocks.
  • The price-to-earnings ratio is a measure of the ratio of stock prices to past earnings, and is a useful indicator for assessing the health of a company.
  • Projected future earnings that reflect growth expectations are also an important indicator of stock evaluation.
  • But the PEG ratio focuses on these two factors and compares the stock’s past earnings relative to the price with the expected future earnings to gain a more comprehensive understanding of the prospects of stocks and companies.

PEG ratio and valuation

Common stock is a requirement for future earnings. The speed of the company’s future earnings growth is one of the biggest factors that determine the intrinsic value of stocks. The future growth rate represents daily market prices in stock markets around the world.

The price-to-earnings ratio shows us the value of stocks compared to past earnings. Most analysts use 12-month tracking earnings to calculate the bottom of the P/E ratio. Certain inferences can be made by looking at the price-to-earnings ratio. For example, high P/E ratios represent growth stocks, while low P/E ratios represent value stocks.

PEG calculation example

ABC Industries’ P/E ratio is 20 times. The consensus of all analysts covering the stock is that ABC’s expected earnings growth over the next five years is 12%. Therefore, its PEG ratio is 20/12 or 1.66.

XYZ Micro is a young company with a P/E ratio of 30 times. The analyst concluded that the company’s expected earnings growth over the next five years is 40%. Its PEG ratio is 30/40, which is 0.75.

How to interpret the PEG ratio

Using the example above, the PEG ratio tells us that the stock price of ABC Industries is higher than its earnings growth. This means that if the company does not grow at a faster rate, the stock price will fall. XYZ Micro’s PEG ratio of 0.75 tells us that the company’s stock is undervalued, which means that its trading is in line with the growth rate and the stock price will rise.

Stock theory suggests that the stock market should allocate a PEG ratio of 1 to each stock. This will represent a theoretical balance between the stock market value and its expected earnings growth. For example, a stock with a return multiple of 20% and an expected return increase of 20% has a PEG ratio of 1.

The PEG ratio result is greater than 1 indicating one of the following conditions:

A PEG ratio result of less than 1 indicates one of the following:

  • The market underestimates growth, and the stock is underestimated.
  • Analysts’ consensus estimates are currently set too low.

Use PEG ratios to compare industries

An important feature of the PEG ratio is that by incorporating future growth expectations into the portfolio, we can compare the relative valuations of different industries, which may have very different current P/E ratios. This makes it easier to compare different industries, which often have their own historical P/E ratio ranges. For example, here are the relative valuations of biotech stocks and integrated oil companies.

The price-to-earnings ratio of biotech stock ABC is 35 times. Its five-year expected growth rate is 25%, and its PEG ratio is 1.4. At the same time, the price-earnings ratio of oil stock XYZ is 16 times, and the expected growth rate is 15% in five years. Its PEG ratio is 1.07.

Although the valuations and growth rates of these two fictitious companies are very different, the PEG ratio allows us to compare relative valuations one by one. What does relative valuation mean? This is a mathematical method to ask whether a particular stock or broad industry is more expensive or cheaper than a large-cap index (such as the S&P 500 index or the Nasdaq index).

Therefore, if the current price-to-earnings ratio of the S&P 500 is 16 times, and analysts’ average expectation of the S&P 500’s earnings growth in the next five years is 12%, the S&P 500’s PEG ratio will be (16/12), Or 1.33.

Using the PEG ratio, you can compare the valuations of two very different industries and understand how they compare to industry benchmarks such as the Standard & Poor’s 500 Index.

Estimate the risk of future returns

Any data point or indicator that uses basic assumptions can be explained. This makes the PEG ratio more like a variable variable and is best used for ranges rather than absolute values.

The reason why five-year growth rates are the norm, rather than a one-year forward forecast, is to help eliminate the widespread fluctuations in corporate earnings caused by the business cycle and other macroeconomic factors. In addition, if a company’s analyst coverage is small, it may be difficult to find a good forward-looking estimate.

An enterprising investor may wish to try to calculate the PEG ratio in a series of return scenarios based on available data and his or her own conclusions.

High dividend-paying stocks can distort the PEG ratio because it does not take into account the income earned by investors; therefore, the PEG ratio is most useful when discussing stocks that are not large dividend participants.

Best uses for PEG

The PEG ratio is most suitable for stocks with little or no dividend yield. That’s because the PEG ratio does not include the income received by investors. Therefore, for stocks that pay high dividends, this indicator may give inaccurate results.

Consider the scenario of an energy utility company with little potential for profitable growth. Analysts estimate a growth of only 5% at most, but years of stable income have brought stable cash flow. The company is currently mainly engaged in the business of returning cash to shareholders. The dividend yield is 5%. If the company’s price-to-earnings ratio is 12, the low growth forecast will give the stock a PEG ratio of 12/5, or 2.50.

An investor can easily conclude with a cursory glance that this is an overvalued stock. For conservative investors focused on generating income, high yields and low price-to-earnings ratios make them attractive stocks. Be sure to include the dividend yield in your overall analysis. One technique is to modify the PEG ratio by adding the dividend yield to the estimated growth rate during the calculation period.

The following is an example of how to add the dividend yield to the growth rate during the PEG calculation period. The estimated growth rate of energy utilities is about 5%, the dividend yield is 5%, and the price-to-earnings ratio is 12. In order to take the dividend yield into account, you can calculate the PEG ratio as (12 / (5+ 5)), or 1.2.

Final thoughts on using PEG

Thorough and thoughtful stock research should involve a deep understanding of the target company’s business operations and financial status. This includes understanding which factors analysts use to estimate growth rates, the risks of future growth, and the company’s own forecasts of long-term shareholder returns.

Investors must always keep in mind that the market cannot be rational and effective in the short term. Although in the long run, stocks may continue to develop in the direction of their natural PEG, short-term fear or greed in the market may put fundamental concerns on the back burner.

When used consistently and uniformly, the PEG ratio is an essential tool that can increase the dimensionality of the P/E ratio, allow comparison across different industries, and always look for value.

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