STOCK TALK: Looking for Bargains with the PEG Ratio
By Frederic Ruffy, Optionetics.com
3/26/2003 3:30:00 PM
After a three-year bear market, some market observers argue that the time is right to look for bargains in the US stock market. According to this theory, many stocks have suffered sharp percentage declines that might have pushed them to attractive levels. Some analysts use the word “undervalued” to describe these stocks that have fallen too far in price. But, just how does one measure whether a stock is undervalued or overvalued? One common way is to look for stocks with low prices relative to earnings, or low price-to-earnings [P/E] ratios. However, using P/E ratios alone can be misleading at times. For that reason, some analysts prefer to use growth rates along with price-to-earnings ratios, and the PEG formula is an easy means for doing so.
As an investor, you have probably heard an analyst or investor say that a stock is attractive because it has a low P/E ratio. This simply means that, relative to the company’s earnings over the past four quarters, the stock trades at a relatively low price. For example, if shares of XYZ Company are trading for $100.00 a share and XYZ has earned $1.00 during the past four quarters, the stock trades at a price-to-earnings ratio of 100 (or $100.00 / $1.00). One hundred is a relatively high price-to-earnings ratio. Low price-to-earnings ratios are in the single digits. For example, if ZYX Corporation earned $1.25 during the past four quarters and the stock trades for $10.00 a share, the P/E ratio would equal 8.00 (or $10.00 / $1.25). Value investors generally look for stocks trading at relatively low price-to-earnings ratios.
Looking at P/E ratios alone can be misleading, however. For example, XYZ Company trades for $100.00 a share, is earning $1.00 a share, and is therefore trading at 100 times earnings. At the same time, ZYX is trading for $10.00 a share, has earned $1.25, and now trades at a P/E of only 8. Which stock is a better buy? Well, suppose that XYZ Corporation is expected to increase earnings at a 50% rate during the next five years, but ZYX is expected to see earnings decline by 50% during that time. After five years, if the stock prices stay the same, XYZ will be earning more than $8.00 a share and trading at 12.3 times earning and ZYX will be earnings less than a nickel a share and trading at a price-to-earnings ratio in excess of 300.
Since earnings change from one year to the next, using P/E ratios alone is not always useful. Instead, some investors prefer to compare P/E ratios with projected growth rates. The price-to-earnings-growth rate, or PEG formula, is a useful tool for doing so. PEG can be computed on any stock that receives analyst coverage and for which there are official earnings estimates. There are a number of sources of earnings estimates today including the Wall Street Journal interactive, Bloomberg.com, and Yahoo! Finance.
The PEG ratio is then computed as the P/E ratio divided by the growth rate. For instance, if XYZ Company has a P/E ratio of 100 and an expected annual growth rate of 50%, the price/earnings-to-growth ratio is 2.00 (or 100 / 50). On the other hand, a stock that has a growth rate that exceeds its P/E ratio will have a PEG less than 1.00. The lower the PEG ratio, the more attractive the stock from a valuation standpoint. That is, it is much better to buy a stock with a high growth rate and a low P/E ratio, rather than a stock with a high price-to-earnings growth rate and a low earnings growth rate. The table below summarizes what to look for when examining specific stocks.
PEG Ratio
Strategy
Less than .50
Aggressively Bullish
.50 to .70
Moderately Bullish
.70 to 1.00
Neutral
1.00 to 1.30
Moderately Bearish
1.30 to 1.70
Bearish
1.70 or more
Aggressively Bearish
One final note: while the PEG formula is useful, it is generally not used as a standalone tool. Instead, prior to establishing a bullish trade, an option strategist might look at technical indicators and chart patterns—then look at the PEG ratio to make sure the stock is not grossly overvalued. On the other hand, if a stock trades at a ridiculously high PEG ratio, the strategist might look at chart indicators and other technical signals for potential trading opportunities to the downside. Either way, when using the PEG ratio, it is best used as a confirmation tool, rather than a factor for dictating whether to establish bullish or bearish positions on specific stocks.
Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
Visit Fred Ruffy’s Forum
optionetics.com
How does KVHI stack up on a PEG basis? According to Yahoo it has a PEG of 1.50:
finance.yahoo.com
The stock definitely is breaking out although the 5 day chart says it is overextended.
RtS |
