In my last post, I discussed about P/E ratio. It is common practice for investors to use the price-to-earnings ratio (P/E ratio) to determine if a company is over or undervalued. There are, however, many extreme cases of stocks trading at 10,000 or more times their earnings - these kinds of situations affect the ratio's accuracy for assessing a company. The companies with a high P/E ratio are typically startup companies with little or no revenues; however, a high P/E does not necessarily mean the stock isn't a good buy 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 / 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:
Brand - The name of a product or company has value. Brands such as McDonald's, Microsoft and General Motors are worth billions.
Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company. It's about time!
Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements.
Barriers To Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. Coca-Cola, for example, has built a very extensive distribution channel--anybody can make pop, but getting that product to the market like Coke does, is very costly.
All these factors will affect a company's growth rate. The P/E ratio does not reflect any of these, and only looks at the past.
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 = (P/E) / (Annual EPS Growth)
Annual EPS growth 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 just like looking at the P/E ratio: a lower PEG means that the stock is more undervalued.
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 50% annual growth in net income and a P/E ratio of 100. The second company is in the beer business. It has lower earnings growth at 24% and its P/E ratio is also relatively low at 12.
Many 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?
P/E ratio (100) divided by the annual earnings growth rate (50) = PEG ratio of 2
P/E ratio (12) divided by the annual earnings growth rate (24) = PEG ratio of .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.
Investors are getting more picky. Many have abandoned the P/E ratio, not because it is worthless, but because they desire more information about a stock's potential. We've realized that the P/E doesn't tell us everything we need to know. Using the P/E along with current growth rates produces the more informative PEG ratio, a great indicator of a stock's potential value.