Value investors often look at the price earnings ratio of a company to see if the price of the stock is potentially undervalued. The price earnings ratio approximates to the number of years of earnings represented by the current share price. If this ratio is low, the value investor may want to investigate further to see if there is a logical reason for the stock price being lower than might be expected. This would generally involve a look at the fundamentals of the company, including an assessment of the management, to arrive at an estimate of the intrinsic value of the company.
The price earnings growth ratio takes the price earnings ratio and divides this by the annual growth rate of earnings per share. Clearly the higher the annual growth rate of earnings per share the lower will be the figure that results from this calculation. The PEG may result in a lower figure for a share that has a slightly higher price earnings ratio but whose earnings per share are growing faster. The PEG may indicate that this share is more attractive because it not only can be bought cheaply in relation to its value but will grow at a faster rate and yield a higher return for the investor.
A low PEG ratio may therefore be indicating a share that is both a value stock and a growth stock. Investors have come to realize that there is no necessary contradiction in this. A value stock does not necessarily have to be a share in a very traditional company that performs solidly without spectacular growth. A growing company can also be undervalued in relation to its intrinsic value as shown by the fundamentals and its shares can also represent a value stock.
The PEG ratio could also show that a company thought of as a growth stock is not growing fast enough in relation to its PE ratio to justify having a much higher PE ratio than a traditional value stock. The application of the PEG ratio could therefore lead an investor to be confirmed in the opinion that the solid growth stock is the better buy. Either way the final decision will be based on further analysis.
The PEG ratio is not a magic formula any more than other metrics that might be studied in order to identify the right shares to buy. The value investor would always look at the potential for growth in earnings as part of the assessment of the intrinsic value of the company. Any likely growth in the future would therefore be factored in by the wise value investor in considering the true value of the stock. The PEG ratio just puts this into a numerical format and allows another method of comparison between two stocks.
The result of using the PEG ratio is not conclusive but should lead to further research into the fundamentals of the company to see if the growth is likely to continue. Investors know only too well in these troubled times that past performance is not a sure indicator of future developments. The reasons for the past growth and the prospects for continued growth would need to be examined taking into account the assets and risk in the company in addition to subjective judgments as to the competence of the management and the quality of human capital generally available to the business.
The investor should look at stocks of familiar industries in which past experience and knowledge can be brought to bear in the analysis of intrinsic value, and should shy away from the unknown. Unless it is possible to understand and predict likely changes in technology in the next five or ten years, cutting edge high technology companies may need to be left alone by many value investors however large the growth prospects of the companies may appear to be. Where a company is conducting its business in a changing landscape of innovative new technology there is a risk of unexpected developments changing the rules of the game. This must always be borne in mind by the serious value investor. The value investor looks into the long term and this is incompatible with certain types of growth stock.
The PEG ratio is another tool for the value investor but cannot be used blindly. This ratio is just another way of looking at stock prices that may yield information that is a useful pointer for further analysis. The ratio can indicate stocks of companies that are growing and still undervalued, but it must be backed up by further analysis before the value investor considers purchasing the stock.