PEG Ratio

I have been using PEG ratio for the past several years with great success. It cannot be used alone but is a very powerful tool when integrated with the basics (price, volume and chart reading). I am going to use the definition form investopedia.com as it makes complete sense and doesn’t get too confusing:

What the PEG Ratio is:
“The PEG ratio compares a stock’s price/earnings (“P/E”) ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock to fully reflect the stock’s EPS growth. This is “normal” in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock’s future earnings growth.

If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently in the Street consensus number. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as “growth at any price”). It could also be that the earnings forecasts have been lowered while the stock price remains relatively stable for other reasons.

If the PEG ratio is less than one, it is a sign of a possibly undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. Value stocks usually have a PEG ratio less than one because the stock’s earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand, it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.

It is important to note that the PEG ratio cannot be used in isolation. Like all financial ratios, to properly use PEG ratios, investors must use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company’s operating trends, fundamentals, and what the expected EPS growth rate reflects. Additionally, to determine if the stock is overvalued or undervalued, investors must analyze the company’s P/E and PEG ratios in relation to its peer group and the overall market.” – provided by www.Investopedia.com

This is the first time that I will try to teach PEG ratio to an extended audience without face to face interaction or a very detailed personal e-mail. I have noticed that people can get confused with my explanation when I try to generalize the procedure that I use.

You must enjoy crunching numbers and have a calculator handy to estimate your own PEG ratio. You also must have access to quality statistical information from the web (past earnings and future earning estimates). A variety of websites produce a PEG ratio but I have not found one site that has a reliable PEG ratio that I can use for my own research, so I calculate it myself, ensuring accuracy with the final number. You will start to realize why I spend so much money making sure that I always have accurate numbers rather than using the free internet sites for my statistics. The free sites work but always cross reference your numbers; this is your hard earned cash that you are dealing with, we wouldn’t want to throw it away because of careless mistakes.

Using Paincare Holdings (PRZ – see the recent case study), I will demonstrate why this stock looks so attractive during this sideways market.

First, you will need to gather the past earnings numbers; going back at least 2 years and going forward two years.

PRZ:
2003: 0.05
2004: 0.14
2005: 0.25 (E)
2006: 0.34 (E)

Now we need to calculate the growth from year to year.
Subtract the earnings of 2004 by 2003 and then divide by 2003.
Repeat the process to determine the growth rate for the following years:

2004: (0.14-0.05)/0.05 x 100 = 180% growth rate

2005: (0.25-0.14)/0.14 x 100 = 78% growth rate

2006: (0.34-0.25)/0.25 x 100 = 36% growth rate

Now, take the current price (we will use the close from Monday night – $5.10) and divide it by 2004 earnings and then by the 2004 growth rate:
2004: 5.10 / 0.14 / 180 = .20 PEG Ratio
2005: 5.10 / 0.25 / 78 = .26 PEG Ratio
2006: 5.10 / 0.34 / 36 = .41 PEG Ratio

Now, I take all three and add them up and divide by the total number:
.20 + .26 + .41 = 0.87

0.87 / 3 = 0.29 PEG Ratio (Very Positive).

Using the definition from above, Investopedia states that a stock is evenly valued at a PEG ratio of 1 in a rational and efficient market. Please note that the stock market is not very rational or efficient so we only use this number as a secondary indicator and tool, after our fundamental and technical analysis is complete. PRZ’s PEG Ratio of 0.29 leads me to believe that the stock is undervalued, compared to its peers and overall market.

To determine a price target going forward, using today’s numbers, we can conclude that $12.50 and $19.50 could be achievable in a rational and efficient market. Remember, we don’t work with rational and efficient markets!

How do I get those numbers?

Use this calculation for 2005
$19.50 / 0.25 / 78 = 1 PEG Ratio

Use this calculation for 2006
$12.50 / 0.34 / 36 = 1 PEG Ratio

I now have an exercise for everyone:
Calculate and determine the PEG ratio and some price targets for LaBarge (LB) going forward. I will upload my results tomorrow during the day to allow everyone to complete the exercise. This is where the education will get fun! This is a nice tool to determine possible price targets and stock valuations. As time moves on, I will introduce another tool to help determine price targets, using charts.

Finally, once you determine the PEG ratio of the stock you are looking to buy, take the time to calculate the PEG ratio for the “sister stocks” in the industry group to see if they have higher or lower PEG ratios. Keep in mind, PEG ratios don’t work for companies with negative or non-existent earnings numbers.

Enjoy,
Piranha