Ask The Expert: How Do I Calculate The PEG Ratio And Why Is It Important?

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Although there are many ways to place a value on a stock, most investors still start their analysis with a price-to-earnings (P/E) ratio. Yet it's a related ratio that will really help to spot value. This week's question sheds light on this little-known valuation tool.

Question: I know the PEG ratio is important, but where do I find the formula?
--Ann E., New York, NY

The Investing Answer: You're right, Ann, it's quite important. Yet you won't find it on any financial websites, or in any analysts' research reports. To figure out this ratio, you'll have to do a bit of quick math.

For the uninitiated, the PEG ratio is the combination of two different inputs. Here's what the formula looks like...

PEG ratio = P/E ratio (which is the current stock price divided by earnings per share) / Earnings growth rate.

Wait, you say. Earnings per share from what year?  The earnings growth rate from what year?

Good questions.

You can use the PEG ratio in the context of trailing earnings (i.e. the most recent fiscal year, or trailing 12 months), or you can use this year's earnings, or even next year's earnings. Let's take a closer look, using this year's earnings as an example.

Let's say that Acme Inc. has a share price of $30, earned $1 a share in 2012 and is expected to earn $1.35 a share this year. Well, from that, we can deduce that this stock has a P/E ratio of 22.2 (30/1.35) and earnings are growing at a 35% pace ($1.35 vs. $1.)

Now plug those numbers into the PEG ratio formula...

PEG ratio = 22.2 PE ratio / 35 earnings growth rate

That leaves you with a PEG ratio of 0.63 -- a great number. As this number is below 1.0, we can see that earnings are growing quickly enough to justify the current P/E ratio.  Said another way, this stock appears to be undervalued, as long as the P/E ratio remains below 35.

But what if the converse was true? What if the P/E ratio was 35 and the earnings growth rate was 22%. Then you'd have a PEG ratio of 1.60. And anytime this gauge moves above 1.0, shares start to become overvalued, at least by this measure.

You can use the PEG ratio for a variety of companies and industries. It's even handy when comparing companies in the same industry. Calculate the PEG ratios of five related firms, and spend most of your final research time on the companies with the lowest PEG ratios.

There are a few notable exceptions to this rule. For example, companies that operate in deeply cyclical industries (such as homebuilders, automakers and energy producers) tend to sport very low P/E ratios when the economy is growing at a fast pace. That's because investors assume that earnings will soon peak and turn down. So these P/E ratios are quite low, but you need to look out several years to get a sense that earnings are expected to keep on rising.

Conversely, these very same stocks may look sharply overvalued when the economy is in a funk, as their earnings will be depressed, leading to very high P/E ratios (and hence high PEG ratios).

That's why the PEG ratio is best used as a tool for companies in the sectors and industries that don't go through booms and busts. The technology sector, which manages to grow at a moderate pace every year, is a great example. Let's look at software provider Oracle (Nasdaq: ORCL).

Oracle has boosted EPS at least 15% in six of the past eight years, and its EPS growth rate over that time stands at 19%. Over the years, any time you bought Oracle's shares when the current (i.e. same year's) P/E ratio was below 19, that would have been a savvy move.

One final thought: Although the P/E ratio is very popular, it doesn't really tell us much. Yet when paired with earnings growth rates, you can get a much better sense if a stock is rightly priced. It's especially helpful if you are deciding between two companiesin the same industry. Give the PEG ratio a tryout the next time you are assessing a group of stocks.

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