Finding Undervalued Stocks Using the PEG Ratio
Finding undervalued stocks is not as difficult as many stock investors believe it is. In fact, there are a number of reliable stock valuation metrics that can be utilized to find undervalued stocks, including a very useful one known as the Price-to-Earnings-to-Growth ratio (PEG ratio). The important thing to remember is that just because a stock is inexpensive pricewise, it does not automatically mean that it is undervalued or cheap when measured using stock valuation methods. On the other hand, just because a stock trades at a high price, it is not necessarily an overvalued stock that should be avoided. In fact, it may be undervalued when viewed from valuation metrics that have stood the test of time, such as the PEG ratio. These metrics can provide useful guidance when making investment decisions.
Determining Value Based on a Stock’s Price-to-Earnings Ratio Is Limited
The most common way to value a stock is a valuation method that you have probably heard financial experts talk about when discussing stock valuations: a stock’s Price-to-Earnings ratio (P/E ratio). A stock’s P/E ratio is simply the price a stock trades at currently divided by the amount the company earned over the past year. A stock that trades for $30 per share and earned $2.00 per share over the past twelve months has a PE ratio of 15 (30 divided by 2).
Understanding how different stocks price to earnings ratios compare to each other is useful information, but it is also static information that is backward-looking and doesn’t take into account future earnings growth prospects. Yes, you can look ahead at how future earnings could potentially affect this ratio for particular stocks, but it ultimately does not provide a clear picture regarding a stock’s valuation going forward as far as growth in earnings is concerned. This forward-looking earnings comparison is best done using the PEG ratio.
The PEG ratio is a powerful tool for finding undervalued stocks to invest in.
The PEG Ratio Calculation
The PEG Ratio Is a Simple Way Find Undervalued Stocks
The PEG ratio is an easy to understand stock valuation method that is a powerful tool when looking for undervalued stocks to invest in. To determine a stock’s PEG ratio, just divide a stock’s P/E ratio by its predicted earnings growth rate over the upcoming year. A stock with a PEG ratio below 1.0 is considered undervalued. The lower the number, the more undervalued the stock is.
Here is an example of how a stock’s PEG ratio is calculated and how you can use it to gauge a stock’s valuation and the likelihood that it will increase in price over time.
Researching a stock you are interested in buying, you learn that it earned $2.00 per share last year, and stock analysts anticipate that it will earn $3.00 per share over the next year. This produces an earnings growth rate (the “G” in the ratio) of 50%. If the company’s stock currently sells for $40 per share, it has a current P/E ratio of 20, dividing the $40 share price by the past year’s earnings of $2.00 per share. With a P/E ratio of 20, the stock you are interested in appears to be overvalued, based on the historical average P/E ratio of 15 that stocks on average trade at. However, when you calculate the forward looking PEG ratio for this same stock by dividing the P/E ratio of 20 by the expected earnings growth rate of 50% (20 divided by 50), you come up with a PEG ratio of just 0.4. Since the PEG ratio for this stock is will below 1.0, it indicates the stock is undervalued and has the potential to increase in price over the next year, as explosive earnings growth bolsters its value. Stocks with high earnings growth rates and correspondingly low PEG ratios tend to outperform the overall stock market, and can make for good investments, especially if they maintain high earnings growth rates for many years.
Just keep in mind that in order for the PEG ratio to provide an accurate view of a stock’s valuation, a company must come through with the earnings growth over the coming year and beyond.
How to Interpret the Peg Ratio for a Stock
The PEG Ratio Helps You Avoid Value Traps When Assessing Seemingly Undervalued Stocks
One of the best things that the PEG ratio can be used for by stock investors is to avoid dreaded value trap stocks. These are stocks that appear to be undervalued because they trade at relatively low prices, but in reality are not, and will likely disappoint value investors. This includes many once high-flying stocks that have fallen greatly from their once lofty heights.
There are inexpensive stocks that appear “cheap” based on the nominal price they trade at (stocks that trade under $10 per share), but have little to no potential to increase substantially in price over time, because little to no earnings growth is projected for them, and thus they have high PEG ratios. Stocks that have high PEG ratios well above the 1.0 threshold are often value traps. Unless they have compelling turnaround stories that will likely increase their earnings in the future, these high PEG ratio stocks should be avoided by those looking for value stocks to invest in.
To find truly undervalued stocks to invest, figure out their current PE ratio and the earnings growth rate that stock analysts are expecting going forward. Then, use these numbers to calculate the PEG ratio for the stocks you are considering investing in. If a stock has a PEG ratio that comes in well below 1.0, it has a good chance of moving higher. Investors love companies that have strong earnings growth. Money is likely to come in and bid the stock’s price up as higher earnings are reported each quarter.
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© 2018 John Coviello