PEG ratio is used to determine the value of the stock while you look at the company’s earnings growth. This gives you a better picture and overview than P/E ratio. Take a look at LinkedIn. Price-to-earnings is just below 1000 now.
A high P/E like that may look like a good buy, but factoring in the company`s growth rate to get the stock`s PEG may tell you another story. A company with a lower PEG ratio may be undervalued given its earnings performance.
The PEG ratio tells you whether the stock is over or underpriced and that varies by industry and what kind of business it is. The accuracy of the numbers in the PEG depends on all the inputs used. If you use historical growth rates, you may provide an inaccurate PEG ratio because the future growth can deviate from historical growth rates. Some use the terms “forward PEG” and some use the terms “trailing PEG” to distinguish between the calculation methods using future growth and historical growth.
The most popular way to compare two different stocks are to look at the P/E. You simply calculate it by taking the current price of the stock and divide it by the EPS. It tells you whether the stock is high or low relative to its earnings.
A stock with a high P/E is often considered as overpriced and that is probably right. It signals that the traders have pushed the stock price too high and above any reasonable near term growth that is probable.
However, a high P/E can also signal a strong vote of confidence that the company still has strong growth prospects in the future. This tells us that the stock price can go even higher.
Investors are usually more concerned about the future than the present. That`s why it is better to look at future earnings growth or the PEG ratio. You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.
PEG = P/E ratio / (projected growth in earnings)
P/E in Company A is 100, and projected earnings growth next year is 20%. PEG in this case is 5 (100 / 20 = 5). Like all other ratios, the number five in this case is just a number you can compare in relationship to others. The lower the number, the less you pay for each unit of future earnings growth. A company with a high P/E and a high projected earnings growth may be a good value.
A company that is not growing any more with a P/E of 10, and a low or no projected earnings growth, gives you a PEG like the P/E. This can tell you that the investment in here is very expensive.
Take a look at the chart below. I have compared Sony with Starbucks. People are not buying vinyl records or cd`s anymore. What do they buy? They simply buy coffee! Sony traded at $120 in year 2000, and now the stock is just below $20. By the way, do you know what company that is selling most cd`s in this world right now? Belive it or not; it is Starbucks!
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