The PEG ratio revisited

The Motley Fool is a good source to get common sense tips for stock purchases. In fact they give the average stock purchaser some practical tools when hunting for value purchases. One such tool is the PEG ratio.

The PEG ratio is what it implies: Price Earnings Growth. The Motley Fool promulgates that a PEG ratio under 1 is an undervalued stock and it has room for growth. Conversely, a PEG ratio in excess of 1 is a stock that is over valued. For example company X has stock that is trading at 25 times earnings. The projected growth over 5 years is 12%. Thus in determining the PEG ratio you simply divide the price earnings by the estimated earnings growth. In this case the PEG ratio is : 25/12 = 2.08 which means the stock is over valued and should be avoided.

Company Y is a different story. The price earning ratio is 12 and the projected 5 year earnings growth is 15%. So the PEG ratio is : 12/15= .80 which makes it an undervalued stock and would be a candidate for purchase. Naturally using only metrics like these are not the only reason you buy a stock. What the company does, its industry and the profitability are important factors as well.

My experience in using the PEG ratio for my own personal purchases has been pretty good. While I'm a retirement income planner and not a stock broker I cannot provide any advise on stocks. What I can do is give my connections a useful little tool for buying stocks. So let's look at the PEG ratio in a different way using the time value of money. I can't take credit for it because I too got this again is courtesy of the Motley Fool.

So lets say a stock is currently trading projected earnings are 12% per year for 5 years and is currently trading at $12.00 per share. Its current PE ratio is 10 so you have enough information to determine if this stock is undervalued. So here's what you do.

First you capitalize the growth over 5 years or 1.12*5=1.76. Then you take the price earnings ratio of 10 and multiply it by the projected compounded growth or: 10*1.76 = 17.6. Now looking at the overall market most people hope to get a 8% return on your stock investments. So to match apples and oranges you discount the projected stock price by 8% over a 5 year period. Using a Net Present Value formula you work backwards or: 1/1.08*5 = .68. Then taking the current value of projected price you discount the $17.60*.68 =$11.97.

Thus using the logic the $12.00 purchase price of the stock is well within the ballpark and is a candidate for purchasing. Of course as mentioned before other factors need to be investigated before you take the plunge. So have a great week connections and happy investing!