# Evaluating Stocks: Understanding and Applying P/E and PEG Ratios

Investors constantly seek reliable methods to evaluate potential stocks for their portfolios. Two widely used metrics in stock valuation are the Price-to-Earnings (P/E) ratio and the Price/Earnings-to-Growth (PEG) ratio. These ratios help investors determine if a stock is overvalued or undervalued and provide insight into its future growth potential. This article explores these ratios in detail, their calculations, applications, and limitations.

### What is the P/E Ratio?

The P/E ratio is a crucial metric that indicates the market value of a stock relative to the company’s earnings. It is calculated by dividing the current market price per share by the earnings per share (EPS):

P/E Ratio=Current Price per Share / Earnings per Share (EPS)

This ratio helps investors determine what the market is willing to pay for a stock based on its past or future earnings.

Example:
If a company has a share price of \$100 and an EPS of \$5, the P/E ratio would be:

P/E Ratio = 100/5 = 20

This means investors are willing to pay \$20 for every \$1 of earnings.

#### Key Insights

1. High P/E Ratio: A high P/E ratio can indicate that a stock’s price is high relative to earnings. This often suggests that investors are expecting significant growth in the future. For example, a technology company with a P/E ratio of 30 might be expected to grow rapidly due to innovations or market expansion. However, it can also signal that the stock is overvalued if the expected growth does not materialize.
2. Low P/E Ratio: A low P/E ratio might suggest that a stock’s price is low relative to its earnings. This could indicate an undervalued stock that might be a good investment opportunity if the company is fundamentally strong. For instance, a manufacturing company with a P/E ratio of 8 could be undervalued due to temporary market conditions affecting its sector.

Find out more about P/E and EPS ratios here.

### Industry Comparisons

It’s crucial to compare the P/E ratios of companies within the same industry. Different sectors have varying average P/E ratios, so comparisons should be made among similar companies. For example, technology companies typically exhibit higher P/E ratios due to their rapid growth rates, while more stable industries like utilities might have lower P/E ratios.

### Earnings per share (EPS)

Earnings per share (EPS) is a key indicator of a company’s profitability, showing how much profit is allocated to each outstanding share of common stock. It is calculated by dividing the company’s net income by the number of outstanding shares. For example, if a company has a net income of \$10 million and 5 million shares outstanding, its EPS would be \$2. EPS helps investors assess a company’s financial health and compare profitability across companies of different sizes within the same industry.

### Limitations of the P/E Ratio

While the P/E ratio is a popular and straightforward metric, it has several limitations:

• Volatile Market Prices: Short-term market volatility can distort the P/E ratio.
• Earnings Makeup: Determining appropriate earnings can be challenging, as earnings can be affected by one-time events, making it difficult to predict future earnings accurately.
• Earnings Growth: The P/E ratio does not account for earnings growth, which is where the PEG ratio becomes useful.

### The PEG Ratio: A Deeper Insight

To address the limitations of the P/E ratio, investors use the PEG ratio, which incorporates earnings growth into the valuation. The PEG ratio is calculated by dividing the P/E ratio by the earnings growth rate:

PEG Ratio=P/E Ratio / Earnings Growth Rate​

To determine the PEG ratio, begin by calculating the P/E ratio, which is straightforward. Then, acquire the stock’s expected growth rate from analyst estimates provided on financial websites that monitor the stock. Once you have these figures, input them into the formula to compute the PEG ratio.

### What Does the PEG Ratio Tell You?

While a low P/E ratio might suggest a stock is a good buy, incorporating the company’s growth rate to calculate the PEG ratio can provide a different perspective. A lower PEG ratio often indicates that a stock may be undervalued considering its future earnings potential. Including the expected growth rate in the calculation adjusts the valuation for companies with high growth rates and high P/E ratios.

The significance of a PEG ratio in indicating whether a stock is over or underpriced varies by industry and company type. Generally, many investors consider a PEG ratio below one to be desirable.

### Example of How to Use the PEG Ratio

The PEG ratio is a valuable metric for comparing companies to determine which stock may be a better choice for an investor. Despite their different industries and growth rates, the PEG ratio allows for an apples-to-apples comparison of their relative valuations.

Assume the following data for two hypothetical companies, Company A and Company B:

##### Company A:
• Price per share: \$70
• EPS this year: \$2.50
• EPS last year: \$2.00
##### Company B:
• Price per share: \$90
• EPS this year: \$3.00
• EPS last year: \$2.00

Using this data, we can calculate the following:

##### Company A:
• P/E ratio: \$70 / \$2.50 = 28
• Earnings growth rate: (\$2.50 / \$2.00) – 1 = 25%
• PEG ratio: 28 / 25 = 1.12
##### Company B:
• P/E ratio: \$90 / \$3.00 = 30
• Earnings growth rate: (\$3.00 / \$2.00) – 1 = 50%
• PEG ratio: 30 / 50 = 0.6

We use the earnings growth rate based on past EPS values for this example. One should refer to analyst estimates available on financial websites that track the stock to find the expected growth rate.

At first glance, many investors might be more attracted to Company A due to its lower P/E ratio. However, when considering the PEG ratio, Company B shows a higher growth rate that justifies its higher P/E ratio. Despite Company A having a lower P/E, Company B is trading at a discount relative to its growth rate. Thus, investors paying less per unit of earnings growth may find Company B to be the better investment based on its lower PEG ratio.

### Conclusion

The P/E and PEG ratios are indispensable tools for stock valuation. The P/E ratio provides a snapshot of a stock’s market value relative to its earnings, while the PEG ratio adds depth by incorporating future growth expectations. However, these metrics should be used in conjunction with other financial ratios and industry-specific analyses to form a comprehensive view of a stock’s potential.

Investors must remain cautious, as no single ratio can fully capture a stock’s worth. A holistic approach, considering multiple financial metrics and the broader economic context, is essential for making informed investment decisions. By understanding and effectively utilizing the P/E and PEG ratios, investors can enhance their ability to identify undervalued stocks with significant growth potential.

Disclaimer: Important information

Access stock’s Shariah compliance status, detailed reports, super investor portfolios, and more with the Musaffa App. Unlock
smart Halal investing and gain insights with our stock forecasts and purification calculator.