It is common practice for investors to use the price-to-earnings ratio (P/E ratio or price multiple) to determine if a company's stock price is over or undervalued. Companies with a high P/E ratio are typically growth stocks. However, their relatively high multiples do not necessarily mean their stocks are overpriced and not good buys for the long term.

TUTORIAL: Understanding the P/E Ratio

Let's take a closer look at what the P/E ratio tells us:

P/E Ratio p/e ratio

There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. After all, earnings represent profits, and that's what every business strives for. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively it will not have positive earnings, and problems will eventually arise. Learn more about how to use the price-to-earnings ratio to reveal a stocks real market value. Read Profit With The Power Of Price-To-Earnings.)

Besides earnings, there are other factors that affect the value of a stock. For example:

  • Brand - The name of a product or company has value. Established brands such as Proctor & Gamble are worth billions.
  • Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company.
  • Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements.
  • Barriers to Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. For example, most anyone can make a soda, but marketing and distributing that beverage on the same level as Coca-Cola is very costly.

All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings (trailing 12 months), it gives a less accurate reflection of these growth potentials.

The relationship between the price/earnings ratio and earnings growth tells a more complete story than the P/E on its own. This is called the PEG ratio and is formulated as:

PEG ratio
*The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing, and either a one- to five-year time span. Check with the source providing the PEG ratio to see what kind of number they use.

Looking at the value of PEG of companies is similar to looking at the P/E ratio: A lower PEG means the stock is more undervalued.

Comparative Value
Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E ratio of 50. The second company is in the beer brewing business. It has lower earnings growth at 10% and its P/E ratio is also relatively low at 15. (There are many other common ratios to use when comparing stocks, such as the P/S ratio. Learn more in How To Use Price-To-Sales Ratios To Value Stock.)

Many investors justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

Networking Company:

  • P/E ratio (50) divided by the annual earnings growth rate (20) = PEG ratio of 2.5

Beer Company:

  • P/E ratio (15) divided by the annual earnings growth rate (10) = PEG ratio of 1.5

The PEG ratio shows us that, when compare to the beer company, the always-popular tech company doesn't have the growth rate to justify its higher P/E, and its stock price appears overvalued.

The Bottom Line
Subjecting the traditional P/E ratio to the impact of future earnings growth produces the more informative PEG ratio. The PEG ratio provides more insight about a stock's current valuation. By providing a forward-looking perspective, the PEG is a valuable evaluative tool for investors attempting to discern a stock's future prospects.

(Every investor wants an edge in predicting a company's future, but a company's earnings guidance statements may not be a reliable source. To learn more, read Can Earnings Guidance Predict The Future?)

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