Dax Desai has made a valid statement in a comment to the “Fund Check Up: Price and Earnings Ratio” post, that during the evaluation of a company, a growth should be taken into consideration. Thus, I’m introducing you to another quite important ratio: the PEG or “price/earnings to growth” or “P/E/Growth”. I have a feeling that such articles can make good series of investment introduction…

P/E or not P/E
I rarely use this ratio, however it can be very useful if you are not sure if a company stock is overpriced(bad thing) or undervalued (very good thing). Usually, P/E ratio can show if the stock is overpriced (P/E is much higher then the industry average value), and when it’s too high, it can suddenly give a signal that the company has a growth potential to feel the gap between the price per share (P) and the earnings per share (E). Holly Molly, I probably just made you very confused…

The most imprecise science
I apologize for that! My university professor of Mathematics asked me once: “What would be the most imprecise science in the world?” I glanced at the old chap and was ready to answer in a second (having high school major in Biology): “That would be Biology, because we just dont know all the mechanics the nature throws at us”. He smiled and told me: “That could be a valid point, but the truth is, that would be Math, and what’s worse, it’s the base for Biology and Chemistry”. Now, after my university and postgraduate studies, I know that he was right - any result in calculations when applied to the reality may give different meanings and opinions…

Growth
If we look at the P/E ratio, it gives us the present situation with a company stock price. But what about the future? When we invest, we assume that we are investing into the growth of the company, thus the growth of the stock price. It is that simple.

So, the PEG ratio can help us to have a glimpse at the company’s potential growth in (mostly)near future. Checking PEG for each company in a mutual fund portfolio will give us a good prospect of the fund’s performance, thus profits for us.

PEG
Alright, let’s look at the most boring part - the calculations of the formulas. As I mentioned before, PEG=P/E/G, which means you need to divide stock price by earnings per share, and then by projected growth in earnings. Do we need to do that manually? Thankfully, no! The PEG number is published in the company’s prospective, so you dont need to mess that much with your calculator. However, we can extract the potential growth number from PEG and make a decision if the company will do good. Note, that PEG shows year-to-year projected(otherwise, it’s only an estimate of probable value, based on present data or trends) earnings growth, and may not be very valuable for very young companies, and not always accurate.

Here is how we do it: G = (P/E) / PEG. That’s it, extracting growth potential by dividing P/E by PEG. PEG and P/E are always published in the company’s profile.

Let’s make an example with our beloved Microsoft(MSFT). I’m using here data from the Yahoo Finance Microsoft statistics page. At this moment, as you can see on the table(left), their P/E is 21.74, and PEG is 1.43. Their potential growth will be G = 21.74/1.43 = 15.20%. Yep, it’s about 15%, which is not bad for an established company with a lot of R&D going on, however there are some rumors they are still losing money on XBox 360 and Zune.

Conclusion
So, how do you relate P/E and PEG, and how can it help you in analyzing the stock prices?

1) A stock with a higher P/E ratio then the industry average, but high projected earning growth may be a real gem in the mud with potentially good value;
2) A stock with a lower P/E ration then the industry average and low or no growth may be a worthless stone in the mud with no value at all…

Share This