Price-to-earnings, or P/E ratio, is perhaps the most commonly used metric used when valuing stocks. However, P/E ratios aren't always useful all by themselves, as they don't take a company's growth rate into account.
For this reason, the price-to-earnings-growth ratio, or PEG ratio, takes the P/E ratio and combines it with the company's expected earnings growth, in order to better express the valuation of growing companies. The PEG ratio is easy enough to calculate -- simply divide the P/E ratio by the company's expected earnings growth rate.
In general, a PEG ratio of less than 1 is considered to be indicative of an undervalued stock and a PEG ratio of more than 1 could imply that a stock is too expensive. However, the PEG ratio is only one piece of the valuation puzzle, and different industries have different average PEG ratios.
Let's say that you're considering two growth stocks in the same industry. The first trades for 18 times earnings, while the second trades for 22 times earnings. So, at a glance the first company may seem like the more attractive investment.
However, the first company is projected to grow its earnings at 12% per year for the next five years, according to the analysts following the company, while the second is forecast to grow earnings at a 16% rate.
Using this information, we can calculate the first stock's PEG ratio as:
And, the second company's PEG ratio is:
The takeaway here is that even though the second company has the higher P/E valuation, it is actually the cheaper of the two when growth is taken into account.
When using the PEG ratio as part of your stock research process, there are a few things to keep in mind.
First, the PEG ratio makes assumptions that may or may not be valid. In our example, we used a projected five-year growth rate, which is a long time. There's no telling exactly when a company's growth could slow down or speed up, so keep in mind that this metric is based on someone's best guess of what will happen.
Also, the PEG ratio doesn't take into account other variables that could add or take away from a company's value. For example, some growth companies keep lots of cash on their balance sheet, but the PEG ratio ignores the obvious value this adds.
Finally, be careful when applying the PEG ratio to slower-growing companies or value stocks. If a certain company trades for 15 times earnings and has grown predictably by 5% per year for decades, its PEG ratio of 3.0 may look expensive. However, with a strong track record of steady growth, this stock could still be a good value for investors seeking safety and stability.
Are you ready to take the plunge into investing? Head over to The Motley Fool's Broker Center and get started today.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.