An interesting article on Bloomberg recently caught my attention. The headline reads, “Cheapest Stocks in 16 Years Draw Investors Amid Rout” (by Lynn Thomasson and Eric Martin). According to the piece, the recent stock market decline has resulted in the best values the stock market has seen since 1991. That, in turn, has created an excellent buying opportunity, according to some Wall Street strategists.

Obviously, “cheap” and “expensive” are relative terms in the stock market. In the Bloomberg article, the writers cite the price-to-earnings [P/E] ratio of the S&P 500 as the measure of value. The S&P 500 includes five hundred of America’s biggest companies. A P/E ratio is computed as the stock price divided by annual earnings per shares. According to article, the S&P 500 is “valued at 15.4 times estimated profit, the lowest since 1991, according to data compiled by Bloomberg.”

Yet, while the S&P 500 is trading has a P/E ratio of 15.4, which is low relative to its price-to-earnings ratio over recent years, there are other factors to consider. That is, looking at a P/E ratio alone doesn’t tell the whole story. It would be like looking at the fuel efficiency of various cars and nothing else. I mean, it would be great to have a car that gets 100 miles to the gallon, but what if that car can’t travel any faster than 5 miles per hour?  Similarly, many investors like to consider a company’s P/E ratio relative to its earnings growth rate? Simply put, faster growth rates justify higher price-to-earnings ratios.

The price-to-earnings growth rate formula, or PEG ratio, is a tool for measuring a stock’s P/E ratio relative to its growth rate.  The formula is straightforward: P/E ratio divided by growth rate.  For instance, if High Growth Company has a P/E ratio of 100 and an expected annual earnings growth rate of 50 percent, the price/earnings-to-growth ratio is 2.00 (or 100 / 50).  On the other hand, Slow Growth Company has a P/E ratio of 5 and an annual earnings growth rate of 7.5 percent. Slow growth has a PEG ratio of .67 (5 /7.5).

The rule when looking at the PEG is, the lower the ratio the better the value. A stock with a high growth rate and a low P/E ratio is better than a stock with a high price-to-earnings ratio and a low earnings growth rate. In the previous example, Slow Growth Company is better than Fast Growth because its earnings growth rate is much better relative to its P/E ratio. The table below summarizes what to look for when looking at PEG ratios. A ratio below .5 is a good reason to consider bullish trades on a stock. A reading of 1.7 or more and look out. The stock could be overvalued. 

Table 1: PEG Ratio

So, back to the S&P 500. What does the PEG ratio say for market valuations today? According to Bloomberg, the S&P 500 is trading at 15.4 times earnings. According to data compiled by Standard & Poor’s, the S&P 500 companies are expected to post year over year earnings growth of 13.05 percent by the end of this year. On that basis, the PEG ratio is 1.18 (15.4/13.05) or moderately bearish (according to table 1).

Importantly, however, there is a risk when using forward looking estimates. The estimates could be wrong. In fact, as we can see from Table 2, estimates for the second and third quarter of 2007 call for single digit earnings growth. It is possible that expectations for the fourth quarter and the remainder of 2007 are too high and could be ratcheted down. If, for example, earnings growth over the next year amounts to 7 or 8 percent, the S&P 500 is two times overvalued, according to the PEG ratio.

Table 2: S&P 500 past and estimated earnings growth rates (by quarter)

Like any tool, the PEG formula is not perfect. It depends on earnings estimates, which are certainly not infallible. In addition, simply because the ratio says that a stock is over or undervalued, it doesn’t necessarily follow that other investors will agree in the short-term. The stock or market can stay under or overvalued. Nevertheless, the PEG ratio is useful in that it offers an easy way to look at valuations of a specific company or the market by comparing P/E ratios with earnings growth rates.     


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
Visit Fred Ruffy’s Forum

• Email This Article
• View Full HTML
• Digg This
• Delicious
• Subscribe

Recent Articles by Frederic Ruffy, Optionetics.com

• January 23, 2009
  Closing Wrap-Up, January 23
• February 25, 2008
  Stock Talk: Visa Proposes Largest IPO Ever
• February 25, 2008
  Morning Watch, Feb. 25
• February 22, 2008
  Sentiment Journal: Boooooooo!
• February 22, 2008
  Morning Watch, Feb. 22