Most stock market traders are familiar with the PE ratio. That is current price divided by the company’s earnings per share (EPS). There are several variations of the PE depending on what EPS timeframe you look at – last 4 quarters, most recent fiscal year, projections for the next fiscal year, etc. – but the idea is the same. Traders often use the PE ratio as a kind of quick and dirty way of evaluating stock value.
I plan on writing a longer article outlining how the PE ratio is tied to EPS growth rates as well as to interest rates. For the simplicity of this discussion, though, it’s sufficient to say that higher EPS growth rates mean higher PE ratios. The question, though, is how high the PE ratio should be relative to the growth rate. That is where the PEG ratio comes in.
The PEG ratio is the PE divided by the annual growth rate of EPS. So if you have a company with a PE of 10 and an EPS growth rate of 10%, the PEG would be 1.0 (10/10=1). Stock traders look at the PEG to see if a company’s stock price is valued properly based on it’s growth rate. For example, a low PE, like 0.30 would suggest a PE that is low in relation to the EPS growth rate. That, in turn, implies that the PE ratio is too low, suggesting that PE expantion (price increase above and beyond EPS growth) could be expected.
As with the PE ratio, though, the PEG cannot be viewed in absolute terms. Before jumping to a conclusion based on an extreme PEG reading, one must look at what is causing it. Make sure to take upcoming earning releases and the impact they will have on the PEG in to consideration. For example, a stock with a 20 PE and a 40% EPS growth rate would have an attractive PEG ratio of 0.5, but if the next set of earnings are expected to drop that EPS growth rate down to 20%, then the reality of the situation is more a 1.0 PEG.
Like the PE, one very useful way of evaluating the PEG is to compare the current reading to historical levels. That will give you an idea of where the current PEG is in terms of where it tends to be for the given stock (and/or industry), which is one more way for you to evaluate the relative value of the stock at current prices.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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