What is a P/E and why is a PEG ratio important?

In the midst of the market correction, some of us may be tempted to buy stocks, perhaps for the first time.  As an amateur investor and stock blogger, two of the more important numbers that are used to evaluate stocks are the p/e and the PEG ratios.  I wanted to take a moment to share with you my understanding and perspective on these particular statistics and why they may be important to consider.

First of all the "P" in the p/e ratio is the "Price" of the stock being evaluated.  This is the amount that an investor would need to pay (in addition to any transaction cost or "commission"), in order to buy a single share of stock.  A corporation is broken up into small bits of ownership called shares.  In a public corporation, this allows an investor to purchase or sell a portion of that company to another investor--by selling the 'shares' that he/she owns to another investor.

Before making any purchase, we all want to make sure that we are paying a 'good price' for the item being acquired.  So how do we do that with a stock purchase?  One of the most important measures of value in evaluating stocks is the p/e ratio.  This compares the Price of a stock with the Earnings.  Earnings should be distinguished from Dividends but they are certainly related.  Earnings are what the company's management has available to it from the operations of a company after expenses have been paid.  In other words, earnings can be considered the "profits" of the activity of a corporation. 

From these earnings, a company can choose to pay dividends, buy equipment or expand operations, make acquisitions, or simply 'bank' the proceeds. 

Thus there isn't anything wrong with buying stocks with lots of earnings relative to the price per share.  These stocks would have relatively small "P's" and relatively large "E's" in the equation.  Mathematically, this would work out to companies with low p/e ratios. 

But what is "low" for a p/e?  Historically, some investors have chosen to have relatively 'absolute' levels of p/e for a stock to consider it a good value.  Suggestions that investors should buy stocks with low p/e's or less or 'avoid buying stocks with high p/e's' can be found if you review the literature.

I would like to suggest that a number like a p/e is a "static" statistic reflecting a value that reflects the current  'value' of a stock based on the current price and the trailing twelve months of earnings.  However, this number fails us as it does not consider the importance of future earnings results on what an investor should pay for a stock.

You might ask 'Why does that matter?'  Isn't it adequate to identify what the current earnings and the current price of a stock is to determine valuation?  And besides, how can we possibly know what the future will bring for a company and besides, I plan on buying a stock today, not next week!

Fortunately, investors have at their disposable, publicly reported estimates by analysts who research the prospects of publicly traded companies and make predictions about future financial results.  These analysts certainly have varying success at this effort and may also utilize the 'guidance' offered to the public by the companies themselves.

There is another financial statistic that one doesn't really need to fully understand to appreciate the possible impact on pricing of equities.  That calculation may be called the "Net Present Value" of a stream of future financial results.  Analysts utilize this concept by estimating future earnings results in the form of a stream of future earnings to calculate the present value of that stream of results.  Thus, realizing that the estimated future results can and should affect the current pricing of an equity points out the limitations of a 'static' figure like a p/e.   

As an example, if investors, examining the prospects of a company's business, believe that the stock will likely earn $1 this year, $1 next year and in fact $1/year for the indefinite future, they might not be willing to place any kind of premium over the p/e beyond the current earnings result.  On the other hand, if we have a company that is earning $1/share this year, estimated to earn $2 next year, $4 the following year and continuing to double its earnings (as estimated) for the foreseeable future, then an investor might suggest that the p/e reflecting the trailing twelve months would be an inadequate statistic to determine valuation.

Thus, the invention of the PEG ratio!  This ratio compares the "p/e" to the "growth" in terms of percentage, generally for the next 5 years.  This ratio is full of possible inaccuracies becuase it is based on the estimates of analysts who can only, at best, make educated guesses!  However, it is a statistic that helps an investor guage the relative value of a stock utilizing the p/e ratio and taking into consideration the growth prospects of that enterprise.

For example, if we take a company that instead of always earning a $1, as I proposed, is estimated to grow its earnings at 10% yearly.  $1.00, $1.10, $1.21....etc., for the next five years.  And let's compare it to a company estimated to be growing its earnings at a 100% rate for the next five years.  This stream, as I wrote above, would be $1.00, $2.00, $4.00, etc.

If both stocks were trading at $10, and both had trailing earnings of $1.00, then both stocks would have a p/e ratio of 10.  But you and I would certainly prefer (I believe) the company growing its earnings rapidly and not slowly, preferring to buy a stock that doubled its earnings (as estimated) rather than one that was expected to grow its earnings at only 10%/year.

We might elicit this valuation difference by utilizing the PEG ratio.  For the company with the 10% growth rate, the PEG works out to 1.0.  The company with the 100% growth rate, however, would have a PEG of 0.1.  Thus, since lower PEG's have better valuation, this could lead us to choose the stock with the 100% growth rate.

In general I consider myself a GARP investor, an investor who examines "growth" but considers the "price", with GARP defined as "Growth At a Reasonable Price".

Hopefully, this adds to your understanding of stocks, and explains some of the numbers that I like to refer to as I analyze stocks and consider whether they are worth buying or not.