Using the PEG Ratio and Value Investing

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Using the PEG Ratio and Value Investing

Usually value investors are looking for stocks with low value multiples or ratios. While there are many of these, probably the most popular version is the P/E or Stock Price to Earnings ratio. The drawback to a P/E ratio is that it does not account for growth. A low P/E may seem good but if the company is not growing, its stock's value is also not likely to rise.

the P/E ratio can be enhanced by including growth and turning it into the PEG ratio. A PEG ratio is calculated by dividing the stock's P/E ratio by its expected 12 month growth rate. One of the most notable proponents of this analysis was Peter Lynch (of Fidelity Investments fame) who suggested that a fairly valued stock will have a growth rate roughly equal to its P/E ratio. That means that a fairly valued stock will have a PEG ratio of 1. A lower PEG ratio may indicate a good value and a PEG ratio much greater than one could indicate that a stock is overvalued.

PEG Ratio Formula

As an example of value investing I introduced the iShares S&P 500 Value Fund (IVE) that replicates the results of a subset of the S&P 500 that meet basic value parameters. This is a good example of the concepts discussed in this article series becuase that fund's P/E ratio and PEG ratios are both lower than the average ratios of all the stocks in the S&P 500 index itself and its performance has been better than the index over the last 5 years. However, if you are not inclined to invest in an ETF, you can easily accumulate a portfolio of stocks with good PEG ratios through one of the many free searches available on the internet. I have included two links to a couple of my favorite, easy to use searching tools below.

- Nasdaq Stock Screener
- Yahoo Stock Screener

Fundamentally speaking, the PEG ratio is more than it appears. In one ratio you have established that the company has profits, growth expectations and a reasonable stock price relative to its financial performance. These are not always givens in today's stock market. Using some minimal fundamental screening within a well diversified portfolio is a great way to remove some volatility from your own portfolio's equity curve.

- You can find out more about fundamental analysis and financial ratios like Return On Equity (ROE) here