PEG Ratio

So with a little bit of valuation technique already covered, I figured I'd take a paragraph or so here to talk about the PEG ratio. For those already familiar with PEG ratios and, more so, for those who don't like PEG ratios, I'm not necessarily going to make an argument here as to whether PEG ratios are the holy grail to valuing stocks, but I will emphasize that whether you like PEGs or not, other investors out there are using them to do valuations so it's a good idea to at least understand them.

Basically, the PEG ratio is the P/E (price to earnings) ratio over the 5-year expected growth rate (though this is a non-decimal growth rate, so you need to multiply the percentage growth by 100). This gives you a number right around 1 that relates the stock's P/E ratio to it's growth rate. Conventional wisdom in the PEG community says that for a stock to be fairly valued, it needs to be trading at a PEG of 1.0x. So, by that, it stands to reason that at under 1.0x PEG the stock is slightly undervalued and over 1.0x PEG the stock is overvalued. An easy example would be MagicBeans company trading at $30/share with expected 2006 earnings of $1.00 and an estimated 5-year future growth rate of 30%. So you end up with a P/E of 30.0x and a PEG of 1.0x -- letting you know that MagicBeans is roughly at its fair value. Pretty simple right?

Of course this isn't an all-in-one beat-the-market-with-this-ratio approach. It has its warts like anything else and so it's always best to use it in conjunction with other research and financial measures. For instance, when I'm evaluating a stock, one of the first things I will do is check out the PEG ratio. If the PEG falls somewhere below 1.5x I'll take a closer look at the stock, and if it is under 1.2x I'll generally take a very close look at the stock. As a value-oriented investor, I will generally pass over a stock that has a PEG of over 1.5x, unless it has some other aspect that I really like - and in that case I may put the stock on my watch list and wait for the price to come down.


-AvgJoe