The price-earnings ratio is probably the most often-referenced ratio by investors and financial commentators. It is calculated by dividing a company’s share price by its earnings per share, and it is often used as a quick way to identify whether a business is cheap.
It is also quite a crude metric that is often both misunderstood by investors and intentionally manipulated by corporate management teams.
Investors should pay attention to things other than earnings, such as free cash flow. Bearing that in mind, I think it is fair to ask: is there a way to refine the price-earnings ratio?
As it turns out, a way already exists, and it is called the price-earnings to growth ratio (aka the PEG ratio). Let’s take a look.
What is it?
The PEG ratio is calculated by dividing the price-earnings ratio by the percentage growth in earnings. It is basically a measure of future earnings growth. By looking at how expensive the business is relative to how quickly earnings are growing, investors and analysts can make a better judgement about whether it is attractively valued or not. Investors use both historical earnings data (backward looking) and estimates of future growth (forward looking) to calculate the PEG ratio.
A key assumption of the PEG ratio is that the current share price of a company represents the future earnings of that business - that is, if a company is trading at $20 per share, then by buying it you are paying $20 today to secure a claim to its future earnings. The PEG ratio is an attempt to quantify whether this is a good deal or not.
What can it tell us?
So now that you know how to calculate the PEG ratio, what can you do with it? The general rule of thumb is that a PEG ratio of 1 indicates that a company is fairly priced. Anything bigger than this indicates that the business is overvalued, while anything less is a sign that it is undervalued.
Why is this? Say our hypothetical example company is trading at $20 per share and has increased earnings by 5% each year for the last four years, and it is expected to continue this trend. Last year, it earned $2 per share, so its price-earnings ratio is 10. Its PEG ratio is therefore 2.
This suggests that the company is overvalued - it is priced for much higher growth than it is actually exhibiting. If that business were growing earnings by 10% a year, then its PEG ratio would be 1, suggesting fair value. If it managed a growth rate of 20%, its PEG would be 0.5, suggesting good value. However, it still does not account for things like dividends and cash flow, so it's best to take it with a pinch of salt.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Jeffrey Gundlach Weighs In on the Recent Market Recovery
- What Cash Flows Can Tell You About Income​
- Howard Marks: Everyone Makes the Same Mistakes
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