Friday, February 3, 2012

Boring Terms We Need To Know: PEG Ratio

In our last "boring terms" post we analyzed the common P/E ratio.  Another ratio that ties into P/E that we use in our dividend growth stock analysis is PEG Ratio.  PEG stands for Price/Earnings to Growth.  This ratio demonstrates a stocks current P/E to its expected earnings growth - typically its estimated 5 year growth.

This term was popularized by Peter Lynch, a very successful investor that works for Fidelity Investments. Peter stated in his 1989 book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its growth rate".  So a fairly valued company will have its PEG equal to 1.  The lower the PEG the more undervalued a stock is based on future estimated growth.

A simple example using one of my favorite stocks, Intel (INTC)
  • Currently has a P/E ratio = 11 
  • Expected 5 year growth rate = 11.6

Now we simply divide P/E by the expected 5 Year growth rate 
  • PEG Ratio = (11 / 11.6) = 0.95

So purely based on INTC's PEG ratio of 0.95, we can deduce that INTC is currently trading just under its fair value.  

There is a major weakness to PEG ratio that I hope you see. There is no way to truly know a stocks future growth rate.  We are relying on analysts' estimates in order to determine this number.  Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, a lack of innovation, market competition, etc...  Since we are relying on estimates to determine this number, we should never solely judge a stock based on its PEG ratio.  It does put a high value on future growth though, and this future growth is a very important aspect when deciding to buy a stock.

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