RATIOS: Evaluation of P/E and PEG ratio for stock picking
Evaluating
of stock is done by two ratios: the P/E ratio and the PEG ratio.
The P/E is the price-to-earnings ratio. It is used to calculate how expensive
or how cheap a stock is relative to its earnings. It tells whether a stock is
overvalued or undervalued. The ratio is calculated as follows:
P/E = Price per share / Earnings per
share
.
The price per share is the current market price for a single share of stock.
The earning per share is the net income divided by the total number of shares
outstanding. Find the net income by looking at a current income statement,
which is available on the company website.
The lower the P/E, the cheaper the stock is. The higher the ratio, the more
expensive the stock is relative to its current earnings. However, that does not
give the full picture. The reason why some companies sometime trade at very
high price-to-earnings ratios is because they are expected to grow tremendously
in the months and years ahead. So, investors are willing to pay more than what
the company is currently worth because they feel the company will be worth a
lot more in the future.
So, one should not shy away from a company with a high P/E. In fact, those
companies are sometimes the best investments, because if their earnings climb
tremendously, then the stock will pay a large dividend in the future. So, a
high P/E ratio can be a very good thing or a very bad thing.
As with a high P/E, a low P/E can also be tricky. If it is low, it could be an
indication that the earnings of the company are expected to plummet, causing
investors to run away from the stock, resulting in a low share price.
Or, the low ratio might indicate that the company is currently undervalued,
making it a good buy because as long as the company is expected to have stable
earnings growth in the future, then the share price will go up. It is not easy
to recognize whether a high or low ratio is good or bad; take into account the
expectations for future earnings growth to understand if the P/E ratio is a
positive or a negative.
The pitfalls of using the P/E ratio to interpret the relative worth of a stock
the PEG ratio is more reliable. The PEG refers to the price-to-earnings growth
ratio.
PEG = (P/E) / Annual earnings-per-share
growth
.
The lower the PEG ratio, the more undervalued the company is. A PEG ratio of 1
or less is considered excellent.
For example:
- If a company has a P/E ratio of 30, and annual earnings-per-share growth of 50%, then the PEG would be 0.6, making this company an excellent buy because it is undervalued and the stock price will almost definitely climb.
- However, if a company has a PEG of 1.5, that means that the stock price is high relative to the earnings growth, which means that unless the company is supposed to grow at a faster rate in the years head, the stock price might not hold up.
The PEG is a much more reliable and effective. It tells whether the high price
of a stock is right based on whether earnings will grow enough to continue to
drive the stock higher.
Analyze stocks and buy the ones that
have a low PEG
. They may not go up right away, but in the long run they
should increase significantly, unless there is something fundamentally wrong
with the company.
Research carefully the companies before investing. It’s often overlooked while purchasing shares. Would you buy a fridge, TV, or even a shirt just by somebody asking you to do so…? NO. Then, why you should purchase stocks without proper study, comparison, and EVALUATION.
