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PEG (Price to future growth ratio) and what it tells you
The
market is usually more concerned about the future than the present, it is always
looking for some way to figure out what is going to happen in the companies
future.
A ratio that will help you look at future earnings growth is called the PEG
ratio.
You calculate the PEG by taking the P/E and dividing it by the projected growth
in earnings.
PEG = (P/E) / (projected growth in earnings)
For example, a stock with a P/E of 30 and projected earning growth next year of
15% would have a PEG of 30 / 15 = 2.
What does the “2” mean ?
Technically speaking: The lower the PEG number, the less you pay for each unit
of future earnings growth. So even a stock with a high P/E, but high projected
earning growth may be a good value.
So, to put it very simply, we are interested in stocks with a low PEG value.
Just for the sake of understanding, consider this situation, you have a stock
with a low P/E. Since the stock is has a low P/E, you start do wonder why the
stock has a low P/E. Is it that the stock market does not like the stock? Or is
it that the stock market has overlooked a stock that is actually fundamentally
very strong and of good value?
To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or
close to the P/E ratio), you can understand that this is probably because the
“projected growth earnings” are low. This is the kind of stock that the stock
market thinks is of not much value.
On the other hand, if the PEG ratio is small (or very small as compared to the
P/E ratio, then you know that it is a valuable stock) you know that the
projected earnings must be high. You know that this is the kind of fundamentally
strong stock that the market has overlooked for some reason.
Important note: You must understand that the PEG ratio relies on the
projected % earnings. These earnings are not always accurate and so the PEG
ratio is not always accurate.
Having understood these basic three ratios, you probably have started to
understand how these ratios help you understand a stock and what is valuable and
what is not.
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