This week, I’m going to focus on a simple strategy that uses the PEG Ratio for determining a company’s undervaluation or overvaluation. Let’s first start with a definition. A PEG ratio is simply the: P/E Ratio divided by the Growth Rate.
A value of 1 or less is considered good (at par or undervalued), while a value of greater than 1, in general, is not as good (overvalued). Once again, the PEG Ratio is simply the P/E Ratio divided by the Growth Rate. Many believe this ratio tells a more complete story than just the P/E.
A company with a P/E Ratio of 25 and a Growth Rate of 20 would have a PEG Ratio of 1.25 (25 / 20 = 1.25). While a company with a P/E Ratio of 40 and a Growth Rate of 50 would have a PEG Ratio of 0.8.
Traditionally, investors would look at the stock with the lower P/E Ratio and deem it a bargain (undervalued). But looking at it closer, you can see it doesn’t have the growth rate to justify its P/E.
The stock with the P/E of 40, though, is actually the better bargain since its PEG Ratio is lower (0.8), implying it’s undervalued with more potential value. (Undervalued in relation to its projected growth rate.) . In other words, the lower the PEG, the better the value because the investor would be paying less for each unit of earnings growth.
So for this week’s screen, we’re going to use the PEG ratio to find value.