The PEG (price/earnings to growth) ratio is a tool that can help investors find undervalued stocks. It’s not as well known as its cousins, the P/E and P/B ratios, but it is just as valuable. When used in conjunction with other ratios, it gives investors a perspective of how the market views a stock’s growth potential in relation to EPS growth.
What the PEG Ratio Is:
The PEG ratio compares a stock’s price/earnings (“P/E”) ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock to fully reflect the stock’s EPS growth. This is “normal” in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock’s future earnings growth.
If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently in the Street consensus number. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as “growth at any price”). It could also be that the earnings forecasts have been lowered while the stock price remains relatively stable for other reasons.
If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. Value stocks usually have a PEG ratio less than one because the stock’s earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand, it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.
It is important to note that the PEG ratio cannot be used in isolation. As with all financial ratios, investors using PEG ratios must also use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company’s operating trends, fundamentals and what the expected EPS growth rate reflects. Additionally, to determine if the stock is overvalued or undervalued, investors must analyze the company’s P/E and PEG ratios in relation to its peer group and the overall market.
The GE Example
We will use General Electric (GE) as a brief example. GE is currently trading at $31 per share and the Street consensus estimate for this year’s (2002) EPS was $1.65. This earnings forecast represents 17% growth from the previous year’s (2001) EPS of $1.41. The current P/E on 2002 estimated EPS is 18.8x ($31 divided by $1.65). This results in a PEG ratio of 1.11 (18.8 divided by 17).
One interpretation of this PEG ratio being greater than one is that the stock retains its “growth” classification, despite the recent bad news surrounding GE, because it is still expected to outperform the rest of the market. Another hypothesis is that institutions are reluctant to sell because GE is considered a core holding and there is currently nothing to replace GE in their portfolios; however, a “normal” stock under normal circumstances would experience a more significant decline in the share price.
A comparison of GE’s PEG to other indexes shows that the market is not expecting much from GE. The current PEG ratio for the Dow Industrials is 1.30 and indicates that the market expects more out of the Dow index than from GE. The PEG ratio for the S&P 500 is 1.88 and reflects the market’s continued demand for growth at any price.
Based upon this limited analysis, we can conclude that, despite GE’s current challenges, the stock still commands somewhat of a premium PEG ratio (1.10). The market, however, will pay more for the potential growth in the Dow (1.30) than for GE. We can also conclude that, despite the recent crash, the S&P 500 still commands top dollar (1.88) for each percentage of potential future earnings growth.
Is GE undervalued or is it the last blue chip to succumb to a slow and painful death like Cisco’s? Finding that answer requires more digging on your part.