One of the most common valuation ratios in finance is the PE ratio, which is the share price of a stock divided by the earnings per share of the company. For example, let’s say a stock trades at $80, and it’s EPS is $10, then the PE ratio is 8. In theory after 8 years, the price of the company will be paid for with its earnings.
However, the PE ratio tells us nothing about the future growth prospects of the company. If you have two companies, with one expected to enter a period of rapid growth with another one to enter a period of slow growth, it would not be fair to value both companies with the same PE ratio. This is where the PEG ratio comes in handy, which is the PE ratio divided by the projected growth rate of the earnings of the company. The essence of the PEG ratio is that a fairly valued company will have its PEG equal to 1, a ratio under 1 is a bargain, and a ratio over 1 implies overvaluation.
This PEG ratio was popularized by Peter Lynch, in his classic book, One Up on Wall Street. The PEG ratio tells an investor how much they are paying for each unit of growth. Let’s assume the above company is projected to have a next period growth rate of 5%. The PE ratio is then 8 divided by 5, which is 1.6. According to the formula, since this is over 1, the stock is over-valued. If the growth rate was 10%, the ratio would be 0.8 which would indicate the stock is undervalued, and the investor is only paying 80c per dollar of growth.
Let’s look at a real example. One of my favourite stocks is Berkshire Hathway. According to Morningstar research, the PEG ratio has ranged from 0.57 in 2014 to 3.70 in 2017 and is currently on a PEG ratio of 0.10, which would imply undervaluation, a strong buy signal.
PEG ratios are fairly useful for-profit making businesses, where the PE ratio is positive. How does one then value a company which is currently loss making then, such as a start up? I will cover this in a separate post on startup valuations.