Macro Monday: The PEG Ratio
I once listened to something very painful: a whackjob salesman try to explain to an ordinary investor what exactly the PEG ratio is and why it is important to analysis. Safe to say, the explanation was HORRIBLY wrong, and it's very unfortunate because the PEG ratio is a great measurement to know.
What is PEG?
Some say that the P/E, or the Price-to-Earnings ratio, is the best measurement for determining if a stock is considered "fairly valued," "overvalued," or "undervalued." The trouble with the P/E ratio is that the number itself means nothing on its own. It has to be relative to another P/E ratio, either from a competitor, the industry, the sector, the market, or the company's own historical average.
It isn't easy to use the P/E ratio because across all sectors, industries, and company sizes the numbers are not standardized.
The PEG ratio makes it easier to determine the proper valuation for any stock. It is essentially this formula:
PEG = P/E Ratio ÷ Annual EPS Growth Rate
So what does the end number tell us?
As a general rule of thumb, a PEG ratio below 1.0 is considered desirable. The closer the value is to 0.0, the more the company's P/E ratio is in-sync with its growth rate.
NOTE: THIS IS ONE OF MANY TOOLS TO ADD TO THE NEW INVESTOR TOOLKIT FOR ANALYSIS! Remember this one.
In the meantime, here's a great explanation and video explaining the PEG from Investopedia:
"PEG is a stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. While a high P/E ratio may make a stock look like a good buy, factoring in the company's growth rate to get the stock's PEG ratio can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.
The PEG ratio that indicates an over or underpriced stock varies by industry and by company type, though a broad rule of thumb is that a PEG ratio below one is desirable. Also, the accuracy of the PEG ratio depends on the inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. To distinguish between calculation methods using future growth and historical growth, the terms "forward PEG" and "trailing PEG" are sometimes used."