Article of the Week from Investing Daily
by Jim Fink, Investing Daily
PEG ratio (n.): A useful investing measure that sounds a lot more complicated than it really is.
Like a lot of investment lingo, PEG ratios can get lost in the alphabet soup, but it’s important to dig in and understand them. They’re a way of evaluating a company’s risk — something you want to understand before you put your own money behind a stock, right? Simply put, PEG ratios put a stock’s attractiveness in perspective by dividing a company’s price-to-earnings ratio (a common valuation measure, and the “PE” in PEG) by its projected future earnings growth rate (the “G”).
Let’s Start With the PEG Ratio
The price-to-earnings ratio, or P/E ratio, is name-dropped all the time with no explanation as to what it really is. Think of it as a term of valuation — a price, if you will.
I know what you’re thinking: Isn’t the stock price the price? Yes and no. The stock price depends on the number of shares issued by a corporation, and that’s a totally arbitrary figure. The number of shares is like the number of slices in a pizza: the more slices, the smaller each piece — but the pie is still the same size. So, simply seeing a stock price of $5 or $100 doesn’t tell you anything about how expensive the stock actually is. In fact, those two prices could reflect an equal value if the $100 is for a company with 1,000 shares outstanding and the $5 is for a company with 20,000 shares outstanding. In that scenario, both companies have a total value of $100,000.
With stock prices telling only a slice of the story, we need a more absolute measurement for value. This is where the P/E ratio comes in: It prices a unit of value, namely earnings. Say the pizza shop on the corner is selling its pies for $10. If some other guy with the same recipe is selling the same pizza for $9, you’d probably go there because you’re getting the same thing for less. The P/E ratio is similar in that it tells you the market price, per dollar, of a company’s earnings.
We now have an absolute unit measure of value, since a dollar of earnings at Company A is worth the same as a dollar of earnings at Company B, just as pizza is pizza no matter where you buy it. (Hold on, there, New Yorkers and Chicagoans — we’re just making a simple analogy here, not throwing down the gauntlet.) Earnings are a good unit of value because they are the profit of a company — money that presumably can be paid out to shareholders in the form of dividends in the future. If you can buy such “future dividends” cheaper at one company, why not do so?
So how do you know that a company will actually pay out its earnings as dividends in the future? You don’t, and that’s why you should reserve a portion of your investment portfolio for companies that pay good dividends today.
Not All Earnings Are Created Equal
If a dollar is a dollar is a dollar, why wouldn’t all companies have the same P/E ratio? When you buy a stock, you’re not just buying the earnings the company makes this year, but also the earnings it’s expected to make next year and the year after that. What if the earnings expectations for next year are $20 for Company A but only $10 for Company B? Wouldn’t you be willing to pay more for a dollar of Company A’s earnings this year if you expected to get much more in the following year? Of course you would. This is why P/E ratios are much higher for companies with high expected earnings growth rates than for companies with lower expectations. So before buying a stock, you need to look not only at its P/E ratio, but at its expected earnings growth rate as well.
The PEG Ratio
Some people divide the P/E ratio by the expected growth rate number, which calculates the P/E per unit of expected earnings growth. This brings us to the PEG ratio. If Company A is selling for a PEG ratio of 1 and Company B is selling for a PEG ratio of 2, you should consider buying Company A because it is cheaper. It can get complicated, though, because the higher expected earnings growth of Company A could be based on an assumption that it will develop a cure for cancer, whereas the lower expected earnings growth of Company B could be based on its plans to add a few stores selling soap. A company curing cancer seems less likely and thus is a more risky bet than selling some soap, right? In other words, comparing expected growth rates requires an evaluation of risk (i.e., the likelihood that the expected growth will actually materialize). Because of that, analysts must adjust a company’s PEG ratio for risk; we’ll save that advanced lesson for another day.
Comparing Pizza to Pizza
Determining whether one stock is cheaper than another requires looking at future earnings, not just present ones, and gauging the likelihood that the expected future growth will actually occur. The only way valuation makes sense — in particular, whether a stock is under- or overvalued — is if you are comparing the prices of similar companies facing similar business risks. Don’t forget to take business risk into account before making a judgment about a particular stock’s value.
PEG Stock Screen
To illustrate this concept, I utilized my trusty Bloomberg terminal to perform a screen of companies that appear overvalued with P/E ratios greater than 30, but whose estimated future growth rates are so high that their PEG ratios are below one, making them possibly undervalued. Keep in mind that many of these are high-risk with uncertain future earnings growth rates:
12-Month Trailing P/E Ratio
Estimated Growth Rate Next 5 Years
Acacia Research (NasdaqGS: ACTG)
China Unicom (NYSE: CHU)
Baidu (NasdaqGS: BIDU)
Qihoo 360 Technology (NYSE: QIHU)
Akorn (NasdaqGS: AKRX)
OSI Systems (NasdaqGS: OSIS)
Harry Winston Diamond (NYSE: HWD)
Read other Investing articles by Jim Fink.