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.

IN PICTURES: 4 Biggest Investor Errors

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.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  2. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  3. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  4. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  5. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  6. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  7. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  8. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  9. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  10. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center