The price-to-earnings ratio is the Swiss army knife of financial analysis for value investors. They use it for everything. It forms the backbone of their investment decisions.
While this ratio is useful, it leaves something to be desired. A stock might seem expensive based on its P/E ratio, but its rapid growth might justify the high number. In these situations, the PEG (price/earnings to growth) ratio can help investors evaluate stocks with spotty earnings records and bright futures.
To calculate the PEG, divide a stock's P/E ratio by the earnings growth rate expected for the next five years. Like the P/E ratio, a lower PEG number indicates a cheaper price. A stock with a PEG ratio of 1 is considered fairly priced. Larger values are more expensive; smaller ones are bargains.
High-growth companies are likely to have big P/E ratios because investors factor the value of potential gains into their stocks, bidding prices up beyond what's logical based on their P/E ratios. Amazon and Apple -- with P/E ratios of 55 and 32, respectively -- are good examples of these situations. Value investors might be inclined to exclude these names, but they would be wise to convert these numbers into PEG ratios before ruling them out.
Amazon is still very expensive based on its PEG ratio of 2.1. However, Apple's 1.38 ratio is close to those of other big technology stocks. IBM has a slightly more attractive ratio of 1.21, while Microsoft and Dell are a bit more expensive at 1.47 and 1.67, respectively.
Without considering its PEG ratio, many investors would pass over Apple because its P/E more than doubles the ratios of IBM, Microsoft and Dell, which range from 12 to 16.
The real bargains in tech appear to be Hewlett-Packard and Research In Motion . With a PEG of 1, HP stock looks fairly valued and cheaper than its competitors. Research In Motion's PEG of 0.67 is downright enticing.
The glut of firms with PEG ratios higher than 1 suggests the market may have been overbought during the rally that started in the spring. Prices have rebounded to levels that seem to surpass companies' fundamentals. The phenomenon isn't isolated to tech stocks; General Electric, Wal-Mart, Exxon Mobil and JPMorgan also have PEG ratios over 1.
Used together, the PEG ratio and the P/E ratio help investors make better decisions by balancing current earnings valuations with projected growth. These value-investing measures will become crucial in these market conditions as people try to separate companies with solid potential from those whose prices are backed by hype.
Follow us on Twitter: