All of you surely know about the P/E ratio, but in case you don't know it, I want to introduce you to his more relevant cousin: the PEG ratio. This metric is defined as the price/earnings ratio divided by 3-5 year growth rate for the stock. To find this growth rate, go to the 'Detailed Research' section of the quote on ZacksAdvisor.com. The lower the ratio, the better in this case since the growth rate is in the denominator. The PEG has all of the benefits of the P/E and more.
P/E DOESN'T CUT IT
As you Zacks readers know fully well by now, earnings, earnings growth, and estimate revisions are vital in predicting the direction of stock prices. The P/E does not reflect these factors at all. Using trailing P/E's is especially useless, since stocks are discounting mechanisms that don't care about what happened in the past. Even forward P/E's do not take into consideration estimate revisions or fast earnings growth. If a company's earnings estimates are being revised sharply upwards, the three to five year growth rate would increase, thus lowering the PEG ratio. Thus, it gives a more accurate read on how much you are paying for a company's growth.
PEG GIVES P/E REASON TO LIVE
The P/E multiple only truly becomes relevant when you know what growth you are paying for. Enter the PEG ratio. This metric allows you to compare stocks from different industries with much more accuracy than just using the P/E multiple. Is an oil stock trading at 20X earnings more or less expensive than a tech stock trading at 30X earnings? That question is impossible to answer without taking into consideration growth rates. If a company like Ebay (EBAY) or Yahoo! (YHOO) in 1999 traded at 30X earnings, it would have been the steal of the century given their respective growth rates. Conversely, a stock like ChevronTexaco (CVX) trading at 20X on the eve of an oil price drop would be expensive.
INTERESTING
Interest rates are clearly a factor that affect PEG ratios. Usually, higher P/E multiples are warranted when interest rates are low, so this would in effect boost PEG ratios. Future earnings are worth more in the present when interest rates are low, so investors are willing to pay more for them. In a rising rate environment like we have now, it is common to see PEG ratios drop, even if earnings are constant. So, it is important to not look at PEG's as a stand-alone figure, but as one of many factors.
START, NOT FINISH
So, what is a good PEG ratio? The common thinking is that a ratio of 1 is considered fairly valued as it equates the valuation to the growth rate. As with all rules of thumb, this is only a guideline and by no means set in stone. Some companies trade at very low PEG ratios because they are out of favor for whatever reason. This could mean that they are undervalued, or it could mean that traders do not believe that the projected growth rates will be met. It is very difficult to determine why a stock has a certain PEG ratio, so it is key that using this metric be one tool among many in your research and investment decisions.
