Tuesday, December 19, 2006

PEG ratio and How to use it

The Price Earnings Growth Ratio compares a stock's price/earnings ("P/E") ratio to its expected Earnings per share growth rate. A Price Earnings Growth ratio should not be used alone. You should also combine it with a few other fundamental ratios. When used in conjunction with other ratios it can be a seriously powerful tool. I prefer to read the numbers availble from huntleys or comsec as you will need a calculator handy to estimate your own PEG ratio. Access to past annual reports and future earnings estmates allow you to provide the current and perceived future PEG ratios.

I have added below an extract from the Investopedia definition:

The PEG Ratio: “The PEG ratio compares a stock's price/earnings ("P/E") ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock to fully reflect the stock's EPS growth. This is "normal" in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock's future earnings growth.

If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently
in the Street consensus number. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as "growth at any price"). It could also be that the earnings forecasts have been lowered while the stock price remains relatively stable for other reasons.

If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. Value stocks usually have a PEG ratio less than one because the stock's earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand, it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.” -
provided by www.Investopedia.com

the key words in the above definition are :

If the PEG ratio is less than one, it is a sign of a possibly undervalued stock

In my expereince we are not going to get great stocks coming under the PEG ratio of 1 but you may get stocks coming close to it. The genreal market ratio for this is 1.6 So in general if a stock has a PEG of 1.6 or lower it is probably going to a contender for analysing.

I prefer to have a PEG of at least 1.5 or less and preferably less than 1.2 . I find these figures throw up a number of stocks which can then be filtered again with other fundamental ratios such as debt to equity, price earnings, price/sales, and dividend yeild to name but a few.

This is a good filter to use to start filtering companies but as indicated it should not be the only indicator. One thing to watch out for is the indicator only works with positive earnings and shouldn't be used with a company that is dropping its earnings ( why you would want to buy such a company sounds bizarre to me ).

Good Luck Investing

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