A well known valuation metric is the PE Ratio (Price / Earnings ratio). This is a measure of a company's share price (P) relative to the annual net income (E). The PE ratio shows current investor demand for a company share. A high PE ratio generally indicates increased demand because investors anticipate earnings growth in the future.
The PE ratio has units of years, which can be thought of as the number of years of earnings required to pay back the purchase price.
The PE ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings.
While the PE ratio is widely used, it is a bit of blunt instrument in terms of valuing a company. One of the biggest challenges of using the PE ratio is that it doesn't consider the growth in earnings of the company. If a company's earnings are rapidly growing, then its conceivable that it should trade at a higher PE ratio. So then the question becomes, what PE ratio is appropriate based upon the earnings and growth rate of the company?
One solution to this problem is to look at the company's PEG ratio.
The PEG Ratio (Price/Earnings to Growth ratio) illustrates the relationship between a company’s stock price, its earning per share, AND the company's growth rate. The PEG ratio consists of the PE ratio divided by the company's earnings growth rate. Using just the PE ratio makes high-growth companies look overvalued relative to others. By dividing the PE ratio by the earnings growth rate, the PEG ratio allows investors to compare companies in wildly different markets by factoring how growth rates affect valuations. By using the earnings growth in the denominator, it helps support the idea that growth is an important aspect to valuing a company.
While not being set in stone, a company with a PEG ratio <1 can be considered undervalued. A company with a PEG ratio around 1 is considered fairly valued, and a company with a PEG ratio much >1 might be considered overvalued, all else being equal.
PEG Ratio = PE Ratio / TTM (Trailing Twelve Months) Earnings Growth Rate*
* Some analysts use a forward PE Ratio and use forecasted earnings growth, rather than trailing PE and historical earnings growth. Using historical numbers rather than forecasted numbers is typically more conservative if growth rates are increasing.
To illustrate a company's PEG Ratio, let's describe a hypothetical company called Blue Star trading at $167.42 per share.
Blue Star EPS (Earnings Per Share) TTM for the following quarters were:
03/31/2020 - 5.12
06/30/2020 - 6.79
09/30/2020 - 7.53
12/31/2020 - 8.16
03/30/2021 - 8.98
So in this case Blue Star could be considered significantly undervalued as the PEG ratio is .247, well below 1.
Both the PE Ratio and the PEG Ratio are great tools that can be used to help value companies and/or compare companies in different industries, as the formulas are straight forward and the information needed is rather easy to ascertain. However keep in mind, calculating these ratios is more than likely just the beginning of the valuation process rather than the end.
-Paul R. Rossi, CFA