A common question most investors ask is even if we identify a company that we believe could have big time upside potential over the next decade or beyond, how do we figure out if that company’s stock is trading at a fair valuation? This is a great question to ask, because when it comes to stocks price and valuation are everything. A very simple method of determining the valuation of a stocks is by utilizing the P/E and PEG ratios.
In the long the run, the degree of analysis that you perform on your holdings should be much more in-depth than just utilizing the P/E and PEG ratios. However, we feel that by understanding these important metrics, it will work as a foundation for you to build off of and continue to grow your stock investing knowledge.
Understanding the P/E Ratio
I’m sure you have all heard of the price-to earnings (PE) ratio. This is an extremely basic ratio that can be found on any investing website. The ratio is calculated as follows:
The P/E ratio is the simplest valuation metric there is for evaluating the attractiveness of a company’s stock price relative to its earnings. It was made popular by the late Benjamin Graham, who was dubbed “The Father of Value Investing;” also well-known for being Warren Buffett’s mentor.
The P/E ratio is a great tool for obtaining a quick and easy idea of how “expensive” a stock is. It tells us how much investors are willing to pay per dollar of earnings for a company. An example would be if a stock was trading at $20 per share and reported annual earnings per share of $1, its P/E ratio would then be 20.
Never Screen By P/E Ratio
Despite its ease of use, utilizing the P/E ratio and assuming that you are performing in-depth stock analysis is a flawed ideology. The P/E ratio fails to take into account how fast a company is growing its earnings. The market will assign a higher P/E ratio to companies that are growing at rapid rates. It is this reason why companies like Facebook (FB), Amazon (AMZN), and Netflix (NFLX) will carry significantly higher P/E ratios than PepsiCo (PEP), Proctor & Gamble (PG), and Clorox (CLX).
Screening for stocks using the P/E ratio is never a good idea! If you say that you are only willing to invest in a stock that has a P/E ratio of less than 20, and you are using a screener such as Finviz.com to do so, this is a losing strategy! You are more than likely limiting yourself to a handful of low growth stocks, and many of these stocks are losers such as GoPro (GPRO). Stocks that are rapidly growing and raising guidance on both revenue and EPS often carry much higher P/E ratios.
Another complication with the P/E ratio is that historically the average has fluctuated. Also take note on the image below that since the mid-80’s the average P/E for the S&P 500 has been trending upward. Opinions vary, however we are under the belief that the valuation landscape of the market has changed with technology. Companies can produce revenue and earnings at a much higher level for nearly a fraction of the cost as past industrial eras.
Despite its flaws, when you do utilize the P/E ratio in your stock valuation practices, make sure you look at both the trailing-P/E and forward-P/E. The trailing-P/E takes into account earnings over the past 12-months, while the forward-P/E gives us a forecast of what the P/E would be when applying the next full-year earnings to the current stock price.
The past has already happened, we don’t care about past earnings. We care about where earnings are headed and that means we need to take a company’s growth rate into consideration.
Utilizing the PEG Ratio
A much stronger method for finding a winning stock is to analyze the PEG ratio. The PEG ratio is calculated as follows:
The reason the PEG ratio is a better metric to use rather than the P/E ratio is because the PEG ratio takes a company’s earnings growth rate into account, providing a more complete picture of the P/E ratio.
When a stock has a PEG ratio of 1 or less, typically this indicates that the stock could be a bargain. Conversely, if a stock is trading a PEG ratio of 2 or higher, this typically indicates that the stock is expensive.
There are many other factors that come into play with this simple valuation method though, the most important factor being how realistic the forecasted growth rate is. When in doubt, always use a conservative growth estimate.
Another issue when relying on the PEG ratio to guide your valuation practices, is that it fails to take into account multiple other fundamentals metrics such as cash flow, return on invested capital, margin trends etc.
Nonetheless, use this information as a foundation for your knowledge. You will keep learning, and the more you learn, hopefully the more you will begin to earn. Our Robinhood Strategy newsletters are great tools for learning how to balance a stock portfolio and screen for stocks.
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- On February 22, 2018
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