How the Peg Ratio Can Help Uncover Value Stocks

A stock's price-to-earnings to growth (PEG) ratio may not be the first metric that jumps to mind when due diligence or stock analysis is discussed, but most would agree that the PEG ratio gives a more complete picture of stock valuation than simply viewing the price-to-earnings (P/E) ratio in isolation.

The PEG ratio is calculated easily and represents the ratio of the P/E to the expected future earnings per share (EPS) growth rate of a company.

PEG ratio = P/E ratio / EPS growth rate

The PEG ratio can be a valuable tool when researching value stocks.

A common stock is a claim to future earnings. The rate at which a company will grow its earnings going forward is one of the largest factors in determining a stock's intrinsic value. That future growth rate represents everyday market prices in stock markets around the world.

The P/E ratio shows us how much shares are worth compared to past earnings. Most analysts use 12-month trailing earnings to calculate the bottom part of the P/E ratio. Certain inferences can be made by looking at the P/E ratio. For instance, high P/E ratios represent growth stocks, while low ones highlight value-oriented stocks.

ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years. Its PEG ratio is, therefore, 20/12, or 1.66.

XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years. Its PEG ratio is 30/40, or 0.75.

Using the examples above, the PEG ratio tells us that ABC Industries' stock price is higher than its earnings growth. This means that if the company doesn't grow at a faster rate, the stock price will decrease. XYZ Micro's PEG ratio of 0.75 tells us that the company's stock is undervalued, which means it's trading in line with the growth rate and the stock price will increase.

Stock theory suggests that the stock market should assign a PEG ratio of one to every stock. This would represent the theoretical equilibrium between the market value of a stock and its anticipated earnings growth. For example, a stock with an earnings multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of one.

PEG ratio results greater than one suggest one of the following:

• Market expectation of growth is higher than consensus estimates.
• The stock is currently overvalued due to heightened demand for shares.

PEG ratio results of less than one suggest one of the following:

• Markets are underestimating growth and the stock is undervalued.
• Analysts' consensus estimates are currently set too low.

A great feature of the PEG ratio is that by bringing future growth expectations into the mix, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This makes it easier to compare different industries, which tend to each have their own historical P/E ranges. For example, here's a look at the relative valuation of a biotech stock and an integrated oil company.

Biotech Stock ABC trades with a P/E ratio of 35 times. Its five-year projected growth rate is 25%, putting its PEG ratio at 1.4. Meanwhile, Oil Stock XYZ trades at 16 times earnings and has a five-year projected growth rate of 15%. Its PEG ratio is 1.07.

Even though these two fictional companies have very different valuations and growth rates, the PEG ratio allows us to make an apples-to-apples comparison of the relative valuations. What is meant by relative valuation? It is a mathematical way of asking whether a specific stock or a broad industry is more or less expensive than a broad market index, such as the S&P 500 or the Nasdaq.

So, if the S&P 500 has a current P/E ratio of 16 times trailing earnings and the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years, the PEG ratio of the S&P 500 would be (16/12), or 1.33.

Any data point or metric that uses underlying assumptions can be open to interpretation. This makes the PEG ratio more of a fluid variable and one that is best used in ranges as opposed to absolutes.

The reason why the five-year growth rate is the norm rather than one-year forward estimates is to help smooth out the volatility that is commonly found in corporate earnings due to the business cycle and other macroeconomic factors. Also, if a company has little analyst coverage, good forward estimates may be hard to find.

The enterprising investor may want to experiment with calculating PEG ratios across a range of earnings scenarios based on the available data and his or her own conclusions.

The PEG ratio is best suited to stocks with little or no dividend yield. That's because the PEG ratio doesn't incorporate income received by the investor. Thus, the metric may give inaccurate results for a stock that pays a high dividend.

Consider the scenario of an energy utility that has little potential for earnings growth. Analyst estimates may be five percent growth, at best, but there is solid cash flow coming from years of consistent revenue. The company is now mainly in the business of returning cash to shareholders. The dividend yield is five percent. If the company has a P/E ratio of 12, the low growth forecasts would put the PEG ratio of the stock at 12/5, or 2.50.

An investor taking just a cursory glance could easily conclude that this is an overvalued stock. The high yield and low P/E make for an attractive stock to a conservative investor focused on generating income. Be sure to incorporate dividend yields into your overall analysis. One trick is to modify the PEG ratio by adding the dividend yield to the estimated growth rate during calculations.

Here's an example of how to add the dividend yield to the growth rate during the PEG calculation. The energy utility has an estimated growth rate of about five percent, a five percent dividend yield and a P/E ratio of 12. In order to take the dividend yield into account, you could calculate the PEG ratio as (12 / (5+5)), or 1.2.

Thorough and thoughtful stock research should involve a solid understanding of the business operations and financials of the underlying company. This includes knowing what factors the analysts are using to come up with their growth rate estimates, what risks exist regarding future growth, and the company's own forecasts for long-term shareholder returns.

Investors must always keep in mind that the market can, in the short-term, be anything but rational and efficient. While in the long run stocks may be constantly heading toward their natural PEGs of one, short-term fears or greed in the markets may put fundamental concerns on the backburner.

When used consistently and uniformly, the PEG ratio is an essential tool that adds dimension to the P/E ratio, allows comparisons across diverse industries, and is always on the lookout for value.