PEG ratio

The P/E ratio (or price-to-earnings ratio) is one of the most well-known valuation tools, but some people neglect to consider the impact of future earnings growth on this ratio.

The price/earnings-to-growth ratio (or PEG ratio), provides a forward-looking perspective and allows investors to compare the relative attractiveness of a stock in the context of the firm’s earnings growth outlook. Similarly to the P/E ratio, a lower PEG ratio means that the stock is more undervalued.

Calculating the PEG ratio is quite simple – divide the P/E ratio by the three- or five-year earnings compound annual growth rate. To better understand how to use the PEG ratio, consider these two technology firms.

• Hewlett-Packard (HPQ) has a P/E ratio of 13.82 and a growth rate of 11.8%
  
• Apple (AAPL) has a P/E ratio of 33.70 and a growth rate of 18.8%
  

Hewlett-Packard is clearly the cheaper company based on P/E ratio alone, but an investor might argue that Apple’s high P/E is justified by its superior growth. Apple has gained a reputation for introducing cutting-edge products and, accordingly, Apple is projected to grow earnings at an annual rate of 18.8%. Hewlett-Packard, on the other hand, is projected to grow earnings at 11.8% rate.

But after calculating both firm’s PEG ratios (Hewlett-Packard is 1.17 and Apple is 1.79) we discover that that Apple’s growth rate, although higher than Hewlett-Packard, does not justify its higher P/E. In other words, Hewlett-Packard’s stock is a better value (even if Apple makes better computers).

As you can see, the PEG ratio is useful for determining whether a firm’s high growth potential justifies their valuation.

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Peter J. Lazaroff, Investment Analyst