In an earlier post, we have introduced the P/E ratio and seen why it is not such a great indication of value stocks because most stocks are low priced because of a reason.
One way to go around that limitation would be to use what is called the PEG ratio or the Price to Earnings to Growth ratio. It is usually obtained by taking the current P/E and then dividing by the future earnings growth (%EPS Growth) of a company. In case the future earnings growth is not available, it can also be obtained by the past earnings growth. Dividing by the Earnings growth applies the effect of scaling the P/E by the growth and takes into account the fact that usually high growth stocks are indeed priced higher and tend to have high P/E ratios. It is this ‘scaling’ that lets us treat a lot of the stocks in the same way. Generally speaking, a PEG ratio less than 1 is considered to be a good value compared to the growth potential it is offering while if it is greater than 1 it is considered to be a little costly.
In Investar, we do not have access to future analyst estimates, hence we use the past earnings growth to compute the PEG ratio. The advisor indicates a “thumbs up” if the PEG ratio is < 1. If you wanted to find stocks priced low compared to their growth potential, you would use the “Earnings growing faster compared to P/E (PEG<1)” scan in Investar to find such stocks.
To summarize, PEG is a much better ratio to use compared to the P/E ratio as it scales the P/E according to its growth and gives you a much better picture of the stock’s valuation.