Meet PEG!

So far while considering how to pick a stock we have looked at:

Return on Equity (ROE)
price-to-Earnings Ratio (P/E)

The price earnings to growth ratio (PEG) is the next factor to consider. Here it is as a math equation you will probably never use:

PEG = P/E divided by earnings-per-share growth

Just when you thought the math part was over. But fear not, when you go to investigate whether or not to buy a stock, you will not have to calculate anything. This will be done for you. In other words, you can look up what you need to know! Once again, Morningstar can show you the PEG ratio for the stock you are investigating on any given day. In the gray bar under your stock selection's name, just click on 'valuation.'

The PEG can be used to figure out a stock's value in a more complete way than P/E alone. Here's what you need to consider:

A PEG of less than 1.0 may be a good value and therefore considered a 'buy.' Stocks with a PEG less than 1.0 have been undervalued and may be ready to grow. This is a signal you are looking at a growth stock.
Greater than 1.0 PEG may not be as strong of a stock pick and is possibly overvalued. These are sometimes 'hold' or 'sell' stocks. (Note: just to make life confusing, some of these are 'buys.' There is no all-or-nothing when considering a stock; there are many, many variables to consider!! It's just that a stock with a PEG greater than 1.0 is not growing as rapidly as one with a lower PEG ratio.)

A few words of caution!

Even with the information above in mind, a stock's PEG ratio should not be the be-all and end-all in your decision making process. There's a lot more to 'buy', 'hold' and 'sell' than the PEG ratio.

Calculating the PEG Ratio

So let's look at Rupert's Rawhides vs Marley's Meaty Treats again! Don't remember these entrepreneurs?? They're from the July 3rd post.

We know the P/E for Rupert's Rawhides is 13.88. Let's say his annual earnings-per-share (EPS) growth over the next 5 years is projected to be 10%. Plugging our information into the above formula, this is what we find:

PEG = 13.88 (P/E) / 10% (EPS growth) = 1.39

Because the PEG is over 1.0, Rupert's stock may be overpriced and considered over-valued. It may not perform as well in the future as stocks with a PEG ratio less than 1.0. But you can still think about purchasing Rupert's Rawhides: Some analysts feel that any stock with a projected earnings-per-share (EPS) growth of over 8% for the next 5 years is a stock worth considering. Also Rupert offers a solid product and some nice dividends. And besides, we haven't even seen the analysts' reports or much else on this stock!

In this 2007 photo, we can clearly see Marley's growth potential is greater than Rupert's at this particular point in time.

Now for Marley's company. The P/E for Marley's Meaty Treats is 20.0. Her company's annual earnings-per-share (EPS) growth over the next 5 years is projected to be 28%.

PEG = 20.0 (P/E) /28% (EPS growth) = 0.71

What can we conclude from this? Marley's Meaty Treats stock is comparatively priced lower than Rupert's Rawhides, and due to its growth potential may be a better buy. Because of its relatively low PEG ratio, we can expect Marley's Meaty Treats to out-perform companies with a higher PEG ratio. Remember though, even though there is potential for the stock price to increase more with Marley's stock, it also has more risk than Rupert's.

PEG Payback

But wait, there's more! Listed on Morningstar's valuation page for any given stock is an interesting number called the 'PEG payback.' What's this, you may ask? PEG payback is a ratio used to determine how many years it will take an investor to double their money.

Yes, double it. For example, if you buy $10,000 of a particular stock, this is the number of years it is projected to take to grow to $20,000. It's no doubt intuitive, but this means the smaller the time frame, the better. Also a shorter time frame implies less risk because the longer we peer into the future, the more hazy and distant it becomes. It's hard to predict too much about the future.

Check for yourself:

To see this is real time, click on the link to Morningstar to see Apple's PEG payback. You can enter any stock in the quote box on Morningstar, go to the valuations page and see this forward valuation.

Examples in today's market-- or more accurately, yesterday's: July 6, 2015-- are interesting to compare. Here are a few forward valuation estimates of PEG payback on a few real well-known companies (and perhaps one you haven't heard of):

Proctor & Gamble: 11.6 years
Disney: 10.1 years
GE: 10.0 years
Microsoft: 9.6 years
Union Pacific Railroad: 8.4 years
Apple: 6.8 years
Hawaiian Holdings: 5.7 years

PEG Payback (years to doubling initial investment)

7 stocks to consider when looking at PEG Payback

Now before you start assuming that Proctor & Gamble is the big risky stock of this group, think again. PG (it's ticker) is considered to be a stock with low volatility. According to Reuters (as of today), "over the past 90 days PG shares have been less volatile than the overall market, as the stock's daily price has fluctuated less than 99% of the S & P 500 index firms." Analysts do not, however, rate PG as a 'buy' at this time. It is considered a 'hold.' This doesn't make it risky, it just means it's not necessarily the time to buy it. And it also means it's not growing right now. PG is a solid value stock that generates money for its investors in the form of dividends.

Remember, all sorts of considerations need to be made before you decide to buy anything. PEG (and its partner PEG Payback) are just a small piece of the decision-making puzzle. Besides--

There is no real crystal ball--BUT!!

This all sounds great and very precise, but actually, it isn't. The truth is, no one truly knows what the future holds. We can examine these numbers all we want, but predicting what a company's growth potential actually is gets a little fuzzy. There is no absolutely sure magical formula or crystal ball for 'potential.'

So what's the point? How do the analysts arrive at their predictions of growth potential?? Before you throw up your hands and give up, they arrive at their conclusions using real numbers and facts from the past & present:

Return on Equity (ROE): yes, back to that! This shows how efficiently the company is being run. Is the ROE for the stock greater or less than the 5-year average? Greater than is good!
Sales: Has the company been making money over the past 5 years? If the yearly earnings-per-share has been 5% or better, this is a good sign.
Cost control: What are the company's profit margins? Even if a company has had great sales, if their expenses have increased at a greater rate, they may actually be not have done as well as it appears.
Growth rate: This is calculated from looking at how a company has grown historically over the past 5-10 years. It involves more math to explain, from which I will spare you-- today!! But it isn't just some arbitrary number assigned because a company has a cool website.

Anyway, that's PEG!! Have a good evening!