What if you could invest in a company that’s not only undervalued but has the possibility of big growth?
Value investors often look to the price-to-earnings ratio (or P/E) as a screen for value stocks. A low P/E ratio is believed to signify that a company is undervalued, but that’s not the only metric that signals value.
Benjamin Graham, long considered to be the “father” of value investing, found that a low price-to-earnings ratio wasn’t enough to unearth the true undervalued companies. He looked to the price/earnings-to-growth (PEG) ratio instead, which combines both value and growth; a more potent combination.
The PEG ratio is calculated by taking P/E and dividing it by the 5-year projected growth rate.
What’s a Good PEG Ratio?
A company that is considered fairly valued will have a P/E ratio that equals its growth rate. So the PEG will equal 1.0. A more expensive stock will be above 1.0.
Normally, a stock with a PEG ratio under 1.0 is considered “undervalued” as that means the market is underestimating the earnings, and/or it is also growing faster than expected.
So, that’s what you should be looking for when you see the PEG ratio. You want a ratio under 1.0.
How the PEG Ratio Really Works
You could have a company with a P/E ratio of 30 and a projected growth rate of 15%. This company clearly doesn’t look like it’s undervalued with a P/E ratio that high. You would be right. Plugging it into the formula, you get 30/15 = PEG of 2.0. Since 2.0 is above 1.0, it is considered an expensive stock.
Let’s say you have a company with a P/E ratio of 40 and a projected growth rate of 50%. With a P/E of 40, it clearly seems to be a bad value. However, plugging it into the formula gives you a PEG ratio of 0.8 (40/50 = 0.8). Since that is under 1.0, it is considered undervalued. The incredible growth rate counters the high P/E Lratio.
In our third example, a company with a P/E ratio of 10, which is well within the value parameters for most investors and is usually considered pretty cheap, has a growth rate of just 7%. Putting it into the formula gets a PEG ratio of 1.43 (10/7 = 1.43), which is much too high to be considered undervalued despite the company’s rather low P/E.