Peter Lynch, the legendary investor advised that the reasonable company stock price, P/E ratio must be equal to earnings growth rate. In order to check if the stock price we buy is reasonable, we will use the PEG Ratio to help filter it further after we have checked the P/E Ratio values. In the previous article, we have already explained what the P/E Ratio is. Today we are going to explain about PEG Ratio.
What is PEG Ratio?
PEG Ratio stands for Price Earnings to Growth Ratio. To find the PEG Ration you will use P/E Ratio (closing price to net earnings) divided by Annual EPS Growth (annual earnings per share growth rate). If PEG is equal to 1 then that stock has a reasonable price to buy. If it’s less than 1, it’s an attractive stock with cheap price. But if it’s more than 2, the stock price is too expensive. There is another easy way to notice, if the P/E is equal to or less than Annual EPS Growth number that is fine. If P/E less than half of Annual EPS Growth, that’s even better. If P/E is more than Annual EPS Growth, then the stock is expensive. Let’s take a look at the example below.
Stock A has a P/E of 20 and is expected to see earnings to growth of 20% year-on-year. So we get PEG equal to 1 (20 divided 20) the stock price is reasonable.
Stock B has a P/E of 20 and is expected to see earnings growth of 10% every year. The PEG is 2 (20 divided by 10), so the stock is expensive.
Stock C has a P/E of 20 and is expected to see earnings growth of 40% year-on-year. The PEG is 0.5 (20 divided 40), so the stock is very cheap.
Some people may have a question, how do we know how much profit and earning that each company could generate year-on-year? The answer is you can try to look at the report and analysis of various brokers to compare. Some even predict future profits for the next few years. Or we may use the average earnings growth rate from the past several years to calculate. And we can also follow news, an interview with the company executive to see what percentage of earnings growth is projected in the latest year.
The PEG Ratio should be used for stocks with consistently high earnings growth and may not be suitable for low growth stocks, or stocks with volatile profits. Importantly, looking at the PEG Ratio should be done in conjunction with other fundamental analysis and the analysis of the business trend, however, during a long bullish trend, it is not easy to find stocks with either low P/E or PEG. Investors may be willing to buy a bit more expensive especially if that is a high-growth company or a super-stock of a company that is in a high-growth industry. And make sure that the growth of the business does not disappear in a short time but persists for a period of time long enough for us to make profitable investments.