Price Earnings Ratio (P/E Ratio) is the ratio between the Current Market Price of a Stock and its latest Earnings per Share. In other words, for any given stock, P/E ratio can be derived by dividing its Current Market Price by its latest Earnings per Share (EPS).
P/E Ratio is a great tool to determine if a stock is under or over priced relative to its listed peers or the market as a whole.
However, while the P/E tells us whether a stock is over or under valued relative to its listed peers or the overall market, it does not tell us whether the stock individually is trading above or below its fair value.
A stock might seem to be trading at a discount when compared to its listed peers, however, it might actually be trading above its intrinsic or fair value.
Price Earnings to Growth [PEG] Ratio
To value a stock, we need to compare the P/E Ratio of the firm to its growth rate in absolute terms.
The Price-Earnings to Growth [PEG] ratio takes the P/E Ratio of a firm and compares it with its Growth Rate. Growth rate is the rate at which the firm’s earnings are growing.
For example, let us assume a firm’s P/E ratio to be 15. Its earnings have grown at the rate of 10 % during the last quarter. Therefore, the firm’s PEG ratio is 15 divided by 10 i.e 1.5
Using PEG Ratio to Value Stocks.
A stock is considered to be fairly priced if its PEG Ratio is equals to One. This is because the stock price is in sync with the growth in earnings of the firm.
Higher the growth rate, the more valuable the firm is considered.
Where the PEG ratio is greater than one, the firm is considered to be overvalued. Similarly where the PEG ratio is less than one, the firm as a whole is considered to be undervalued.
PEG Ratio is based on the assumption that investors value growth firms more and are willing to pay a higher price for them.
Note that while PEG ratio is a good measure of whether a particular stock is over or under valued, it is important to remember that no ratio should ever be considered in isolation to take investment decisions. We must always consider the other factors at play while taking any investment decisions.