While many individual investors are familiar with the conventional Price to Earnings (P/E) ratio, the PEG ratio isn’t cited nearly as often but it really puts a stock’s valuation in the proper context. While a P/E ratio will tell you whether a stock is “highly priced” just based on a forward earnings expectations or trailing earnings reports, a PEG ratio is the P/E ratio divided by the stock’s long term annual growth rate. Now, the problem is estimating just what that growth rate will be. But for relatively mature companies with transparent investor updates, it’s not too tough to reasonably discern whether you’re in the right ballpark.
PEG Ratio vs. P/E Ratio:
Consider two stocks.
1) Mature industrial company with steady earnings year over year. P/E = 10.
2) Nimble, fast growing company. P/E = 45.
Let’s say the broad market is trading at an aggregate Price to Earnings ratio of 12. One investor may view stock 1 as a “value” and stock 2 as being absurdly overpriced. However, when looking at each in terms of their projected growth rate, the pendulum swings the other way. If stock 1 is a utility that’s expected to grow at about 5% per year and stock 2 is growing at 30% per year, in the context of future growth, the PEG ratios tell a different story:
1) Stock 1 PEG ratio = 10/5 = 2
2) Stock 2 PEG ratio = 50/25 = 1.5
Stock 2 now appears to be much more of a value. Often times, stocks with high growth rates are more volatile and prone to massive price swings. But if you’re able to hang on to a stock for a few years and the projected growth rate assumptions are reasonable, you’re often rewarded with a higher net return. This is broadly reflected in the long term outperformance of tech stocks, biotech stocks, small caps and emerging market stocks vs. their counterparts.
When I provided my last portfolio update you will have noticed that many holdings fall into the stock 2 bucket since I’m young and have a long time horizon and my ultimate goal is to maximize investment returns. Conversely, when I’m 55 and approaching retirement, I will likely be more focused on stability and income via high yield investments. So, there’s no “right” way to invest, but it’s important to consider the context of your investments as well as your time horizon.
Do You Use the PEG Ratio in Evaluating Stock Purchases?
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Both are great ratios when it comes to stocks, but to get the best and most accurate reading on the value of a stock you need to look at its intrinsic value. And to do this you need to at least run it 10 years out.
The PEG ratio is indeed a valuable tool, but only for certain types of stocks. I noticed in your latest post that your portfolio is mostly growth stocks, and the PEG ratio is indeed quite useful for growth companies.
The PEG falls short when used for low-growth companies, though, and it’s unhelpful to compare PEG ratios between a high growth and low growth company. For example, a company with zero growth that pays a large dividend will have a PEG of infinity (well, sort of, divided by zero. So if growth is, say, 0.5%, PEG will be extremely high).
The PEG also fails to take into account a dividend (as does the P/E, of course). When I use PEG ratio I typically add the dividend yield to the growth part of the equation to balance this out.
So in your above example, assuming both companies have have modest debt levels, I’d likely invest in the one with the higher PEG (especially if it pays a dividend). A company with a P/E of 10 and a growth rate of 5% is a pretty deep value if it also pays a solid dividend.
So basically my point is that I only use PEG ratio when considering high P/E investments, as otherwise it doesn’t provide useful information.
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