Some of the market's biggest winners were trading at prices above 30 times earnings before they made their move.
A stock with a P/E below 10 may be a better deal than another trading at a P/E above 20. But then again it might not.
The point is, when you become a part owner in a company, you have a claim not just on today's earnings, but all future profits as well. The faster the company is growing, the more that future cash flow stream is worth to shareholders.
That's why Warren Buffett likes to say that "growth and value are joined at the hip."
You can't encapsulate the inherent value of a business in a P/E ratio. It's actually growth that determines value.
The PEG ratio is used to evaluate a stock's valuation while taking into account earnings growth. A rule of thumb is that a PEG of 1.0 indicates fair value, less than 1.0 indicates the stock is undervalued, and more than 1.0 indicates it's overvalued. Here's how it works:
If Stock ABC is trading with a P/E ratio of 25, a value investor might deem it "expensive." But if its earnings growth rate is projected to be 30%, its PEG ratio would be 25 / 30 PEG.83. The PEG ratio says that Stock ABC is undervalued relative to its growth potential.
It is important to realize that relying on one metric alone will almost never give you an accurate measure of value. Being able to use and interprete a number of measures will give you a better idea of the whole picture when evaluating a stock's performance and potential.
A stock with a P/E below 10 may be a better deal than another trading at a P/E above 20. But then again it might not.
The point is, when you become a part owner in a company, you have a claim not just on today's earnings, but all future profits as well. The faster the company is growing, the more that future cash flow stream is worth to shareholders.
That's why Warren Buffett likes to say that "growth and value are joined at the hip."
You can't encapsulate the inherent value of a business in a P/E ratio. It's actually growth that determines value.
The PEG ratio is used to evaluate a stock's valuation while taking into account earnings growth. A rule of thumb is that a PEG of 1.0 indicates fair value, less than 1.0 indicates the stock is undervalued, and more than 1.0 indicates it's overvalued. Here's how it works:
If Stock ABC is trading with a P/E ratio of 25, a value investor might deem it "expensive." But if its earnings growth rate is projected to be 30%, its PEG ratio would be 25 / 30 PEG.83. The PEG ratio says that Stock ABC is undervalued relative to its growth potential.
It is important to realize that relying on one metric alone will almost never give you an accurate measure of value. Being able to use and interprete a number of measures will give you a better idea of the whole picture when evaluating a stock's performance and potential.
Why We Look at the PEG Ratio
One of the more popular ratios stock analysts look at is the P/E, or price to earnings, ratio. The drawback to a P/E ratio is that it does not account for growth. A low P/E may seem like a positive sign for the stock, but if the company is not growing, its stock's value is also not likely to rise. The PEG ratio solves this problem by including a growth factor into its calculation. PEG is calculated by dividing the stock's P/E ratio by its expected 12 month growth rate.
How to Score the PEG Ratio
Pass—Give the PEG Ratio a passing score if its value is less than 1.0.
Fail—Give the PEG Ratio a failing score if its value is greater than 1.0.
One of the more popular ratios stock analysts look at is the P/E, or price to earnings, ratio. The drawback to a P/E ratio is that it does not account for growth. A low P/E may seem like a positive sign for the stock, but if the company is not growing, its stock's value is also not likely to rise. The PEG ratio solves this problem by including a growth factor into its calculation. PEG is calculated by dividing the stock's P/E ratio by its expected 12 month growth rate.
How to Score the PEG Ratio
Pass—Give the PEG Ratio a passing score if its value is less than 1.0.
Fail—Give the PEG Ratio a failing score if its value is greater than 1.0.
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