It is common practice for investors to use the price-to-earnings ratio (P/E ratio or price multiple) to determine if a company's stock price is over or undervalued. Companies with a high P/E ratio are typically growth stocks. However, their relatively high multiples do not necessarily mean their stocks are over priced and not good buys for the long term.
Let's take a closer look at what the P/E ratio tells us:
| P/E Ratio = | Market Value per Share |
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| Earnings per Share (EPS) |
There are two primary components here, the market value (price) of the stock and the earnings of the company.
Earnings are very important to consider. After all, earnings represent profits, for what every business strives. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively it will not have positive earnings, and problems will eventually arise.
Besides earnings, there are other factors that affect the value of a stock. For example:
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All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings (trailing twelve months), it gives a less accurate reflection of these growth potentials.
The relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. This is called the PEG ratio and is formulated as:
| PEG Ratio = | Price/Earnings Ratio |
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| Annual EPS Growth* |
| *The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing, and either a one- to five-year time span. Check with the source providing the PEG ratio to see what kind of number they use. |
Looking at the value of PEG of companies is similar to looking at the P/E ratio: a lower PEG means that the stock is more undervalued.
Comparative Value
Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E ratio of 50. The second company is in the beer business. It has lower earnings growth at 10% and its P/E ratio is also relatively low at 15.
Many investors justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?
Networking Company:
P/E ratio (50) divided by the annual earnings growth rate (20) = PEG ratio of 2.5
Beer Company:
P/E ratio (15) divided by the annual earnings growth rate (10) = PEG ratio of 1.5
The PEG ratio shows us the sexier high-tech company, compared to the beer company, doesn't have the growth rate to justify its higher P/E, and its stock price appears overvalued, particularly when this comparison is made.
Take Google, for example, which provides us with an opposing angle of vision when applying the PEG ratio to its current pricing. Google's share price, since its IPO, has headed straight for the stratosphere. At time of writing it had a P/E of 47 and an expected earnings growth next year of 33%, which gives us a PEG of 1.40. The Nasdaq 100 Index a P/E of 30 and an estimated earnings growth rate of 15%, which produces a PEG of 2.0. Judging by the PEG ratio, Google is relatively undervalued compared to its pricier Nasdaq 100 benchmark. .
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