September 21, 2007 2:38 am

I am often asked to explain what is the PEG Ratio. This is a great tool to help understand the valuation of a stock in the context of the future earnings potential. This is a tool that should be used in conjunction with others in order to discern of the stock is reasonably valued.

If you want to learn how to profit from the MSN Money Screening Tools, buy The Disciplined Investor only $14.95! the best 15 bucks you will ever spend! Available now in our online store

At the bottom of this post is a listing of those stocks that have PEG Ratios significantly below their peer group. The MSN Money Stock Screener was used to find candidates within the Large Cap Universe of the S&P 1500.

The P/E ratio is helpful when looking at the relative valuation of one stock as compared to another, but it is only useful when accompanied by the understanding that it should only be used to compare stocks in similar sectors and industries. It would make no sense at all to compare the P/E of a utility stock to the P/E of a technology stock—that would be like comparing apples to oranges.

To level the field, an excellent derivation of the P/E ratio is used to see if a stock is valued fairly compared to its own future growth. This is called the PEG ratio or earnings to growth ratio.

PEG RATIO

The calculation: price/earnings (P/E) ratio divided by expected per-share earnings growth over the next year.

More than likely, a result that is less than one tells us that we may have a good investment that is undervalued for the time being. On the other hand, a result of more than one is usually a sign that the position is valued higher than it should be. Originally, the PEG Ratio was developed to look at stock statistics in more than one dimension. By adding expected growth to the P/E ratio, it will effectively provide a comparison tool to level the paying field when valuing stocks.

Originally, the PEG Ratio was developed to look at stock statistics in more than one dimension. By adding expected growth to the P/E ratio, it will effectively provide a comparison tool to level the paying field when valuing stocks. Small to Mid-Cap stocks are well suited to utilize the PEG Ratio as the initial screening tool since they usually pay little or no dividends. In effect, is a good tool for some stocks that are usually more difficult to value using traditional methods.

Just as it is true that the ratio is beneficial for smaller stocks, larger stocks should have an additional requirement to help create a more usable and more appropriate valuation tool. By simply adding an overlay of dividend yield along with the earnings, a much better outcome can be crafted for largecap stocks.

Here is a quick guide for using the PEG Ratio as a part of your investment disciplines:

PEG Ratio Signal Guide

50 or less -> Strong Buy

50 to .75 ->Buy

75 to 1.00 ->Hold

1.00 to 1.25 ->Possible Sell

1.25 to 1.75-> Consider Shorting

Over 1.75 ->Short/Sell