I keep hearing about the Fool Ratio. What is it and how do I use it to find stocks?

The Fool Ratio. also known as the PEG, is a bit of numerical fun that helps us determine if a small cap, fast growing stock is a bargain or not. Basically it compares the stock’s price (in terms of its P/E or price-to-earnings ratio ) to its growth rate. We have all the details about what it is and why it works in Step 10 or our 13 Steps to Investing Foolishly. To read it on AOL, click here: #10: How to Value Growth Stocks. To read it on the web, click here

Also important, though, is what it is NOT. It’s not our primary stock picking tool. In the Motley Fool Investment Guide we outline eight criteria for picking small cap stocks. The Fool Ratio is just one criteria. Focusing on a low Fool Ratio without checking out the other fundamental factors is like thinking a stock is a bargin because it is only $1 per share. Very dangerous.

The Fool Ratio flows from the premise that, for a small cap growth stock, a reasonable market price would be the one that puts its P/E ratio at the same level as its earnings growth rate. According to this premise, a company that is growing at 20% a year would deserve a P/E around 20, while one growing at 50% a year would deserve a P/E in the neighborhood of 50. This is discussed in detail below in topic #5.

(For those of you who are getting lost in the acronyms, PEG stands for Price/Earnings/Growth ratio. The P/E is already a well-known number available for any company with earnings. The growth rate is harder to find and relies on analysts’ estimates of earnings growth. Instructions for calculating the earnings growth rate are in Step 10 — see link above. The PEG compares the PE with the company’s projected earnings growth rate. Basically, to arrive at the PEG, you divide the PE ratio by estimated annual earnings growth rate. When they are about the same — for example, when the P/E is 21 and the growth rate is 20% — the value of the PEG is close to 1.0.)

Getting the DATA to calculate the PEG

To calculate the PEG (Fool Ratio), you will need the most recent 4 quarters of earnings (trailing earnings), the stock price, estimated earnings for at least a year (preferably more) in the future, and the number of earnings reporting periods (quarters) between the last reported earnings and the time of the estimate. A good source for all of this data can be found on our website — www.fool.com — in the upper left area of the page. Just enter a stock symbol in the box and click Get Info, then click on Financials.

Sources for earnings estimates are easy to find for larger companies, but sometimes it’s not so easy to find them for smaller companies. If you can’t get earnings estimates for a company you are interested in, try the following:

1. Call the company’s Investor Relations Department or chief financial officer (CFO) and see if you can get them to provide a two-year annualized earnings growth projection.
2. While you’re on the phone with the IR Dept. ask them to give you the names of companies who are direct or indirect competitors. By getting the competitors’ financials, as well as speaking with them on the phone about your company, you might get some important info.
3. Post a note on the stock message board or to the appropriate folder in our Industry & Market Analysis message boards. maybe other Fools interested in the stock or the industry will have something to add to your findings.

If you can’t get any hard numbers, consider waiting until you can. If the company is the next Microsoft (like you hope), it won’t hurt you in the long run to wait a few quarters before investing — and it might save you a bundle if things go wrong.

Is the Fool Ratio a universal tool? Can I use it to evaluate any company regardless of size or sector?

No, the Fool Ratio cannot be applied universally. It works best with small growth stocks. It cannot be used to value cyclical companies like semiconductor and chemical manufacturers, airlines, utilities, or financial companies like banks. It is also not useful in valuing large, well-established companies.

The company I am following shows earnings that are declining for the next several years, but I still think it is a great long-term buy. What does the Fool Ratio say for a situation like that?

Since a company with a shrinking earnings per share (EPS), temporarily or not, does not fit in the growth category, the straight PEG becomes a poor way to value it. If earnings are declining, you might expect the price to follow, so this may not be the right time to buy it. If you can get earnings estimates far into the future that show a return to growth, you might be able to use those, but the PEG is really only designed to value stocks that are growing.

I understand the limitations of the Fool Ratio (can’t be used for cyclical companies, large companies, etc.). Just how do I value such firms? Must I resort to reading tea leaves or consulting the I Ching?

Nope, nothing so mystical as that. There are numerous ways to value cyclical companies, but they are often complicated and involve considering the P/E of the firm in relation to the economic cycle. See the series of articles in the Fool’s School called How to Value Stocks for ways to arrive at a value that don’t require positive or growing earnings.

OK, so you can’t use the PEG on cyclical companies. What about large-cap stocks? Will the PEG approach work on them? If not, what is the best approach to come up with comparable results? Is this the occasion to use the YPEG that I’ve seen mentioned here and there?

Yep, the YPEG (year-forward PEG) is a really simple way to value companies that are large enough that one can place reasonable confidence in their earnings estimates and growth rates. Remember, the market values companies based on what it expects in the future. The question is never What have you done? but What will you do? Thus Wall Street tends to base valuations on next year’s earnings as long as the company is large enough that next year’s earnings are likely to be accurate.

The YPEG is a very simple way of doing that. You multiply a company’s estimated earnings growth rate (use the 3, or better yet, 5 year growth rate if available) times its estimated earnings for the next year. Here’s the logic behind it: If the P/E should equal the growth rate, and if large company stocks are valued on their estimated earnings, then you should be able to simply multiply the estimated earnings times the growth rate to get a reasonable stock price.

So the YPEG gives you an estimate of the current fair market value of a stock. If the stock is selling for less than its fair market value, then it is one that you might consider buying.

Here’s an example. Tom Gardner Inc. manufacturer of buggy whips, has $1.00 in trailing earnings. The company has loads of cash and $5 billion in sales. Analysts follow it like horse flies follow the buggies it serves. So we feel confident in using next year’s estimates and the analysts’ estimated growth rate.

Estimates for earnings 12-months forward are for $1.25 per share, and the company has a projected 5-year growth rate of 21%.

21 x $1.25 (growth rate x year-forward earnings) = $26.25

The fair price for Tom Gardner Inc. is $26 1/4.

Now, you might want to also consider just how reliable your estimates are. Don’t get so caught up in the numbers that common sense is left behind. Do you really think Tom Gardner Inc. has that great a future?

But why should the PE equal the growth rate?

OK, I see how to calculate it and when to use it, but I still don’t understand why the PEG works. I mean, who says that the P/E should equal the growth rate? You don’t expect us faithful Fools to just take your word for it, do you?

Absolutely not! We would strip those Foolish epaulets from your shoulders instantly if you took our word for anything! There is a very logical reason why the Fool ratio works — i.e. Why we consider a stock fairly valued when the P/E and growth rate are equal (or when the PEG=1.0). It has to do with those magic words: The Time Value of Money.

OK, let’s look at two stocks, ABC Inc. and XYZ Inc. For purposes of this discussion, we are assuming that all other factors are equal. Lots and lots of other stuff goes into valuing a company, but we are just looking at a single factor here, the relationship between the P/E and the growth rate, so we are going to hold everything else constant and equal.

Both companies are selling for $20 and both earned $1 a share last year. So both have a P/E of 20. Now, suppose that ABC Inc. is projected to earn $1.20 next year and to continue to grow at a 20% rate for the next five years, and XYZ is projected to earn $1.40 a share next year and to continue to grow at 40% a year. (We are assuming that the projections are equally accurate.) Now, in five years, ABC will be earning $2.48 per share. We are holding the P/E constant at 20, remember, so that would put the stock price at around $50. Nice gain.

Meanwhile XYZ grows earnings at 40% per year. After 5 years, it is earning $5.38 per share (that’s compound growth for you. ) If the market still thinks a P/E of 20 is appropriate for this company, it would be selling for $106. (I know it’s hard to imagine a company that has grown earnings at 40% a year selling for a measly 20 times earnings, but we are being conservative here.)

Now, what would you pay more for today. something that was going to be worth $50 in 5 years, or something that was going to be worth $106? Trick question. The real question is how much MORE would you pay? And if we throw in this set of ginsu knives, how much MORE would you pay?

Sorry, got carried away, there.

To calculate how much more the faster growing company is worth, you can do a Time Value of Money calculation that discounts the future value of an investment back to today’s dollars (a Present Value calculation). The trick to finding the present value is coming up with the appropriate discount rate (sometimes called the opportunity cost rate — essentially it represents what you think you could earn on some other investment.) In this case, the alternative investment is appreciating at 20% per year. If you perform a Present Value calculation on ABC company, you would find that if ABC Inc. will be worth $50 in five years assuming a 20% growth rate, its value today is $20 — so it checks. Of course, it’s no coincidence that the discount rate is the same as the growth rate.

The actual formula is Present Value = Future Value at year n divided by (1+ the interest rate) to the nth power, where n is the number of years forward you are going. Whew!

According to my HP 10B Business Calculator (God’s gift to finance majors), if ABC Inc. is worth $20 a share in today’s dollars (FV = 50, n = 5, i = 20), then XYZ should be worth $42.60 (FV =106, n = 5, i = 20) today. $42.60 corresponds roughly to a P/E of 40 — which is more or less the growth rate. Thus, the Fool Ratio (PEG), which says that in a full and fairly valued situation, the P/E should equal the growth rate. Or, to put it really, really simply, a company that is growing twice as fast is worth twice as much.