How can I use the PEG ratio to value stocks?
No "right" answer here - looking for a solid, cohesive argument.
Best Answer
2183 points
ChaosNantuko answered one year ago …
The PEG is PE divided by Growth Rate. This is used to serve as an approximation for how expensive the business is in respect to how fast its growing. The problem is, its a bad approximation. Just like money compounds, so to does a growing business. If a business is growing at 50% annually, then in 2 years, its earnings are 2.25 times as high as they originally were. If a business is growing at 25% annually, its earnings are only 1.56 times as high as they originally were. Basically, if the growth rate is cut in half, that doesn't mean the business is worth half as much (as implied by the PEG) and if the growth rate doubles, that doesn't mean the business is worth twice as much (once again implied by the PEG).
On companies of similar PE ratios, PEG is a fair, if backwards way of comparing companies. On companies with drastically different PE ratios, you'll find that a similar PEG ratio can mean vastly different things.
Compare two hypothetical companies... one with 200 P/E and 200% earnings growth (tripling earnings every year), and one with 20 P/E and 20 Earnings growth.
If they continue at that rate, then 3 years later, the first company is making 9 times more, the second is making 1.7 times more, and so the first one would have a P/E of 22, still growing at 200% Earnings growth, while the second as a P/E of 11, but is only growing at 20% Earnings growth. These companies are vastly different in terms of management effectiveness, and what your paying for the earnings growth, yet they would have the same value for PEG. This problem becomes even larger as you look over longer time spans, such as 5 or 6 years, as the earnings growth becomes more and more significant.
Basically, as i see it, PEG is a bad approximation for how much your paying for the growth of the company. You'd be much better off making a spreadsheet with various earnings growths and time periods to see how many times more money the company will be making in x number of years, and then just do PE divided by this growth over time factor to get an estimate of how much your paying for growth.
Answers
1130 points
sundarkambam answered one year ago …
What one is basically looking is the Return on stock.
Return on stock is inversely tied to the PE Growth ratio by the formula:
( 1+R)raised to power of n = (1/PEG)*[1+PE for year 0/(100xPEG)]raised to power n.
The complete analysis can be found at
http://lloydsinvestment.blogspot.com/2007/10/how-can-i-use-peg-ratio-to-value-stocks.html
104 points
scott715 answered one year ago …
PEG is PE divideded by the Growth Rate of earnings. Jim Cramer says to sell when it hits 2 and below 1 is a steal. The PEG can be found on Yahoo Finance. But be careful the number is not always right or the PE could be temporarily off.
A fast growing company should increase in value rapidly and if you get it at a low PE that is cheap then you got a double good buy.
3943 points
MNSL answered one year ago …
Not only earnings but also Brand, People who manage, potential and expectations, successful long term strategy etc all affects for the value of stock and will affect a company's earnings growth rate. Because PE ratio calculated on fast earnings it does not reflect these growth potentials.
On the other hand PEG ratio gives a more complete picture of sock valuation. It gives idea about future prospects and accounts for growth potentials. PEG ratio can be calcualatd simply dividing the PE ratio by the earnings growth rate. Lower PEG is better and higher ratio is expensive. Normally companies with PEG values between 0 to 1 may provide higher returns. PEG ratio that exceed 2 is over priced and too high. PEG ration can be used to detremine whether the compny’s higher P/E reflects higher growth in the future or higher stock price.If the company's PEG ratio is less than one, it is considered to be undervalued.
It is common practice to use PE ration among investors to determine whether stock price is over or undervalued. They say companies with a high P/E ratio are growth stocks. P/E ratio is useful to compare companies in the same sector. It can not be used for companies belong to different growth prospects and sectors.
However PEG is only one indicator to value stocks. This is only suitable for growth companies and not suitable for low growth companies. This has become highly questionable.
