The PEG Ratio Explained
When it comes to stock valuation, one man's bargain is another man's ripoff. Many stock pickers rely on the popular Price to Earnings (PE) ratio. The PE ratio divides a company's share price by its earnings per share to give a rough indication of relative value. The problem with the PE ratio is that it measures one company against an industry average. If the industry is overvalued to begin with, a relatively low PE doesn't necessarily translate to an investment opportunity. For this reason, some stock analysts prefer the Price to Earnings to Earnings Growth (PEG) ratio.
The PEG ratio takes a company's PE ratio and divides it by earnings per share growth. For example, company ABC has a share price of $20 and earnings per share of $2. This gives the company a PE ratio of 10. If the company's earnings per share growth is 10 percent, the PEG would be 1. It's assumed that a fairly valued company has a PEG of 1. Suppose the company's earnings per share tumbles to $1 and the stock price remains $20. Now, the company's PEG is 2 assuming earnings growth remains constant at 10 percent. This implies that the company is overvalued. In other words, investors are paying an unjustified premium given the current growth rate.
While far from perfect, the PEG ratio offers a litmus test of sorts when gauging relative value. Use it wisely!
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.