The PEG Ratio, short for price-to-earnings to growth ratio is a quick short hand of figuring out which stocks are possibly undervalued. The current conditions make for very elevated levels of market valuation of most equities except for a couple of sectors (commodities and energy). In searching for undervalued stocks, looking at the PEG ratio may provide you with a clue.
The PEG Ratio
A stock’s PEG ratio is simply the Price-to-Earnings ratio divided by the (expected) earnings growth rate. Note that technically, PEG ratio can indicate “forward PEG” or “trailing PEG”. Since we are only concerned about the future earnings for new investment dollars, it is a good idea to look at the forward PEG ratio in evaluating stocks. The lower the PEG ratio, the more undervalued a stock is. A rule of thumb used in the industry to evaluate stocks is looking for a number less than 1 – indicating that a stock is possibly undervalued. The PEG ratio provides a better picture than simply looking at the P/E of a stock. For e.g., you may choose to use a screener and exclude high P/E stocks, say anything over 20. This may not be the best course of action, as the high P/E might be justified if the company is expected to grow its earnings aggressively over the next few years.