Some stocks typically trade at a higher price-to-earnings ratio (P/E) than other stocks. Often this is related to the industry that they are in. For example, the average tech stock is typically afforded a higher P/E than the average industrial manufacturing company. This is likely due to investors' perceptions that a tech firm has a higher likelihood of developing an exciting new product that will greatly increase earnings than does a typical manufacturing firm. Stocks can trade based on expectations as much as they do actual results. Many times tech stocks trade at a fundamental premium because of the hope that one day they will be the next big thing, whereas established industrial and manufacturing firms are usually set in their ways and are not as likely to create the next big innovation.
As a result, it can be difficult to compare "apples to apples" when comparing the P/E for different companies. One method value traders use in an effort to make comparisons across different industry groups is to compare a company's P/E to its actual growth rate. This ratio is typically referred to as the Price/Earnings to Growth ratio (PEG).
Components of PEG ratio
The PEG for a stock is computed by dividing the P/E ratio for a company by the company's growth rate (i.e., the annual growth in earnings per share). This simple measure allows a trader to assess the relative value offered by a given stock, particularly when compared to other candidates.
If a company has a growth rate of 10 percent and a P/E of 20, then the PEG is 2.0 (20 / 10). If the P/E ratio were only 10, then the PEG would be 1.0 (10 / 10). In basic terms, the lower the P/E and/or the higher the growth rate, the lower the PEG. The higher the P/E and the lower the growth rate, the higher the PEG. Typically, the lower the PEG, the greater the value offered by the stock because it indicates a low P/E, which is preferred, and/or a large growth rate, which is also preferred.
What traders look for
The goal of a trader looking at PEG is to attempt to get "the most bang for the buck." The trader is willing to buy a stock with a higher P/E, but only if doing so is justified by a higher growth rate in earnings.
Consider the stocks of two companies—one a technology company, the other a manufacturing company. Let's say that the tech stock sports a P/E of 25, while the manufacturing stock trades at a much more modest P/E of 10. From a strict "value" standpoint, one can make the argument that the manufacturing stock is a better value because it trades at a much lower P/E. But now let's factor in earnings and growth.
For the sake of the example, let's say that the tech company grew its earnings by 50 percent in the last 12 months. Meanwhile, the manufacturing grew its earnings by 10 percent. Using PEG, here is how these two companies would compare:
• Tech Stock PEG = (25 PE / 50 percent growth rate) = PEG of .5
• Manufacturing Stock PEG = (10 PE / 10 percent growth rate) = PEG of 1.0
A value-oriented trader in this example might deem it reasonable to buy the tech stock despite its higher P/E because the tech company has a PEG ratio that is half the value of the manufacturing company's PEG. Again, one of the primary reasons to consider PEG is to be able to compare companies across various—and very disparate—industry groups.
What traders look out for
One word of caution regarding PEG is that companies can typically only grow their earnings at exorbitant rates for a limited period of time. Buying a stock with a P/E of 200 based on an earnings growth rate of 100 percent may be fine as long as the company remains in a major growth phase. But eventually that type of growth rate is bound to slow. And when that day comes the stock may be marked down by investors and traders as they adjust to the reduced expectations for the company.
PEG is typically best used to compare companies that have exhibited an earnings growth rate within a consistently reasonable range. In other words, a trader will generally get more useful information by comparing companies that have historically similar growth rates than by comparing one company which grew its earnings in the last 12 months by 300 percent to a company that previously showed strong earnings growth and in the last 12 months earned only 2 percent.
Alert traders may also pay attention to the current PEG for a given company compared to its own historical PEG range. For example, if the PEG for a popular growth stock reaches an exorbitantly high level, this can be a sign that the stock's growth phase has run its course.
Relating a company's P/E to the company's earnings growth is a simple but elegant way to normalize results. This process affords traders a slightly more insightful perspective regarding the value of a given company, particularly when looked at relative to other comparable companies.