Understanding Stocks

102 UNDERSTANDING STOCKS
just because the P/E is high doesn’t mean that the stock should be
avoided (although the risk is higher). In general, you can use the P/E to
determine quickly if a stock is cheap or expensive when compared with
its peers and the overall market. (By the way, pay attention to the P/E of
the entire market. For years, the P/E of the S&P 500 was hovering
above 30, a clue that the market was overvalued. Some analysts believe
that the S&P 500 will have to drop to a P/E of 15, its historical average,
before it will be fairly priced.)
Price/Earnings/Growth: Taking the P/E One Step Farther
The P/E ratio is quite useful, but it doesn’t take into account future
earnings potential. That’s what the price/earnings/growth (PEG) ratio is
designed to do. To calculate the PEG, instead of simply dividing the
stock price by the earnings (as you do for the P/E), you divide the P/E
by the earnings growth of the company. For example, if a company has
a P/E of 20 and an annual earnings growth rate of 10 percent, the PEG
will be 2. This allows you to take into account both the P/E and the
company’s growth rate in determining the value of a company. Many
people feel that the PEG is more accurate than the P/E because it takes
future growth into account.
The guideline for PEG users is as follows:
A stock with a PEG of less than 0.50 is desirable (undervalued).
A stock with a PEG between 0.50 and 1 is good (fair value).
A stock with a PEG higher than 1 is not recommended, especially
if the PEG is over 2 (overvalued).
Warning:You should use the PEG as only one piece of a larger calculation.
Do not decide to buy a stock based solely on its PEG results.
For the most complete and accurate calculation, it is suggested that
you use the PEG to compare stocks within the same industry. The
problem with the PEG, like that with the forward P/E, is that you are
basing your information on earnings estimates, which have historically
been unreliable. That is why it is so important that you use a variety
of tools before deciding to buy or sell a stock.