When speaking of stock valuation, the first metric that usually comes to mind to measure value is the price to earnings (P/E) ratio. This is a useful tool when comparing companies with relatively stable earnings, but when a firm's earnings are less than stable and the company is just in the growth stages of development, a more relevant measure of assessing value may be the price-to-earnings-to-growth (PEG) ratio. This ratio allows you to compare companies with different growth rates, and see if the stock is undervalued or overvalued once growth is taken into consideration.
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According to one of the most successful fund managers of all time, Peter Lynch, "The P/E ratio of any company that's fairly priced will equal its growth rate..." and further, "if the P/E of Coca-Cola is 15, you'd expect the company to be growing at about 15% a year, etc." So, a fair valued stock, according to Peter Lynch, would be equal to one.
With that said, let's take a look at some of the PEG ratios for a much hyped up sector, the cloud computing companies:
1. Riverbed Technology, Inc. (Nasdaq:RVBD)
Estimates from analysts have pegged Riverbed's earnings to grow at a rate of about 28% for the next five years. With a current P/E ratio of 253, this results in a PEG ratio of 9.
2. Salesforce.com (NYSE:CRM)
One of the bigger and more talked about cloud computing companies in the sector, analyst estimates for Salesforce's earnings growth are roughly the same as for Riverbed, averaging at about 27%. So with a P/E ratio of 240, this leads to a PEG ratio of 8.9.
3. Ariba Inc. (Nasdaq:ARBA)
Ariba, based out of Sunnyvale, California, has one of the lower estimates for earnings growth. Over the next five years, the company is expected to grow earnings by 17%, which equates to a PEG ratio of 8.0.
4. VMware, Inc. (NYSE:VMW)
VMware is one of the larger companies on this list, with a market cap of $37 billion. Its growth rate is forecast to be around 24% per year, and which results in one of the lower PEG ratios of this group, at 5.20.
5. NetSuite, Inc. (NYSE:N)
I saved Netsuite for last because the company doesn't generate any current earnings, so neither a P/E ratio nor PEG ratio can be calculated for the company. However, that hasn't stopped the company's stock from soaring over the last year, rising over 60% in the trailing 12 months.
The Bottom Line
Based on the PEG ratios we calculated, there appears to be a lot of hope and speculation embedded in the valuations of many of these stocks. Do all of these stocks deserve such lofty valuations? Probably not. I suspect the stock several of the weaker players in this space will acquaint themselves with gravity sooner or later. (For additional reading, take a look at PEG Ratio Nails Down Value Stocks.)
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