Friday, June 22, 2007

Evaluating stock using the PEG Ratio.

P/E Ratios

In evaluating stocks, many people look at the P/E multiple, or the Price to Earnings multiple. This is found by dividing the stock’s current price by a companies trailing or expected future earnings.

For example, if we look at the stock of General Electric (GE ) as of June 22, 2007, we see the trailing P/E ratio is 18.95. and the forward or estimated P/E ratio is 15.36.

Difference between Trailing and Forward PE

You might ask, what is the difference between the Trailing and Forward PE ratio? The trailing PE ratio refers to the price divided by the previous twelve months earnings. Those earnings were already reported, so the trailing PE can’t be debated. Trailing PE is a way to see how the company did in the last twelve months.

Now the Forward PE ratio is calculated by dividing the current stock price by the estimated 12 months future earnings. There are analysts out there who predict how much a company will make in the next twelve months. Using the Forward PE is a way of seeing how a company will do in the future.

I personally prefer looking at Forward PE because I prefer looking at where a company will be going more than where a company’s been in the last 12 months.

Is it better to buy a stock with a low PE or high PE?

Looking at the PE multiple by itself, it is hard to judge whether it is better to buy the stock. A company with a high PE might be justified in having a high PE because it is growing at a very fast rate. A company with a low PE might be priced correctly because it is growing at a very slow rate. However, what if a company has a high PE but the company is growing at a very slow rate? Or what if a company has a low PE but the company is growing at a very fast rate? With the former, you would say that the company is greatly overvalued. With the latter, you would say that this is a bargain!

PEG Ratio

Based on this, we can’t look at the PE ratio to judge a company. We want to buy a company that is reasonably priced with respect to its growth rate. So that’s where we come up with the PEG ratio, or the PE ratio divided by the companies growth rate.

Using GE again, we find. that GE has a forward PE of 15.36, and the 5 yr growth rate of 10%. So that means the PEG of GE is: 15.36/10 = 1.536.

So how do we use this number?

In general, if the PEG of a company is less than 1, the company is considered a very good value. If the company has a PEG greater than two, the stock is considered very expensive and it is best that it be avoided. With GE above having a PEG of 1.53, it is reasonable, but not extremely cheap.

Comparing PEGs

We could compare stocks and compare PEGs and choose the lower ones, but we could do better. It’s better to compare the PEG of a company with its competitors or its industry because each sector might have a different range of good PEGs. You can use the PEG to choose the best stock in a sector.

Finding the information through Yahoo Finance

Now, you might want to know how to find the information in Yahoo finance. Go to finance.yahoo.com and enter your stock. You can see a nice summary page and find news stories about the stock, a companies market cap, and the Trailing PE ratio.

To find more details about the stocks, go to the Key Statistics tab. You can find the Trailing PE and the Forward PE. The PEG Ratio is also mentioned, but I prefer to calculate the PEG ratio myself.

If you want to manually calculate the PEG ratio yourself, you can find the forward PE, and then find the 5 yr estimated growth rate through the Analysts Estimates Tab. Go to the bottom part of the page and look for the 5 yr Estimated Growth. The Growth Rate of GE in this page is 10%.

So Forward PE = 15.36, Growth = 10%, so PEG is 1.536.

This investing style (by using PEG ratio) is called Growth At a Reasonable Price or GARP.

Improved Version of PEG incorporating Yield and Cash Per Share

The PEG ratio above is biased against slower growers with lots of cash and a good yield. So in order to incorporate this fact, I’ve developed the MyPEG. More information in this link.