How do you know a stock is expensive? Part 2

Last week we wrote an article about how to determine whether a stock is expensive or not and used the price to earnings (P/E) ratio to explain this. There are, however, issues with this simplistic ratio. This is because it does not take into account the earnings growth as it only looks at historical earnings which may change.  The price earnings ratio also does not take into account the debt the company has.

The next step above the P/E ratio is the PEG ratio.

What is the PEG ratio?

Where the P/E ratio looks at earnings, the PEG ratio also takes in account a company’s earnings growth.

The PEG ratio is represented as:

PEG = (share price/EPS) / EPS growth rate

This ratio allows you to evaluate the stocks value in comparison to the earnings per share, but also takes into account the earnings per share growth rate.

These ratios are important as it is useful for investors to compare ratios incorporating the company’s future earnings

Comparing PEG ratios

If a stock has a PEG below one it is undervalued, the stock is priced less than the predicted earnings growth.

If a stock has a PEG of 1 it means the price of the share is in line with the predicted future earnings growth.

If a stock has a PEG of above one it is overvalued. This means that the investors in the market expect it to deliver more growth then the predicted growth rates.

Example of PEG ratio

If we look at two companies below which are within the same sector, you can see Company Yellow has a higher EPS growth rate than Company Green. The PEG is also lower for company yellow which is below 1 which means the stock is undervalued compared to Company Green which is above 1. This example shows that Company Green has a P/E which is higher than industry average and also a PEG ratio which is more than 1. This tells us that this stock is overpriced when earnings growth rates have been considered.

Disadvantages of using the PEG ratio

This ratio does not value mature companies accurately as older companies may not have high growth rates but may have other valuable characteristics such as dividends and business stability.

Also the PEG ratio does not factor in company debt which can affect the stock price.

Next week in Part 3, we look at a company’s enterprise value to earnings.

Lauren Hua is a private client adviser at Fairmont Equities.

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