AS WE'VE NOTED frequently, stocks with strong growth rates tend to attract a lot of investors. All that attention can quickly drive their multiples above the market average. Does that mean they're overvalued? Not necessarily. If their growth is superior, they may deserve a higher valuation.
The PEG ratio helps quantify this idea. PEG stands for price/earnings growth and is calculated by dividing the P/E by the projected earnings growth rate. So if a company has a P/E of 20 and analysts expect its earnings will grow 15% annually over the next few years, you'd say it has a PEG of 1.33. Anything above 1 is suspect since that means the company is trading at a premium to its growth rate. Investors usually look for a PEG of 1 or below, although as we explain in a minute there are exceptions.
Here's how to put the ratio to work. Say Dell Computer is trading at a forward P/E of 35 times earnings. After making the comparison and discovering that rivals Compaq Computer and Gateway 2000 are both trading at multiples around 20, you might begin to think Dell looks awfully expensive. But then you look at earnings growth. First, you see that Dell's earnings are expected to grow at 40% annually over the next three to five years, while analysts are predicting Compaq will grow at 15% and Gateway at 20%. That would give Dell a PEG of 0.88, while Compaq weighs in at 1.33 and Gateway at 1. Looked at in that light, Dell doesn't seem so pricey after all.
Generally you use a forward P/E in the PEG ratio, but a low PEG using a trailing P/E is even more convincing. Anything below 1 is of interest, although there really are no rules of thumb. Like the P/E, different industries regularly trade at different PEGs. It's also true that the PEG works less well for large-cap companies that by nature grow at a slower rate despite strong prospects. As always, the key is to compare a company to its peers.
The PEG ratio's weakness is that it relies heavily on earnings estimates. Wall Street tends to aim high and analysts are often dead wrong. In 1998, for instance, some companies in the oil-services sector routinely had projected earnings growth rates in the 35% range. But by the end of the year, the crash in oil prices had them swimming in losses. Had you been impressed by their bargain-basement PEG ratios, you'd have lost a lot of money. Our advice is to shave 15% from any Wall Street growth estimate out of hand. That provides a good margin of error.