Earnings per share are the basis of the many fundamental analysis ratios. But what do those numbers mean in context? Is the EPS number good for this stock, sector, or price level? Shouldn't a rising EPS be rewarded more than a high but stagnant profit?
The next step is to compare the EPS of the company with other figures such as share price and future anticipated growth.
Price to Earnings Ratio (P/E) as Fundamental Analysis
One of the very first ratios an investor will want to know is earnings per share as related to share price.
- Share Price / Annual Earnings = Price to Earnings Ratio
This is also known as a price or earnings multiple. For example, imagine a stock earned one dollar per share over the last 12 months. If the stock is trading at 10 dollars per share this give a P/E ratio of 10. If the stock is trading at 20 dollars per share the P/E equals 20 and so forth. The idea is that the trader can then see how high share price is compared to the earnings. This will help him to determine if the stock is over-valued, under-valued, or on par with its peers.
It is important to note the two types of price to earnings ratios. The first takes in the previous 12 months of data and is called a trailing P/E ratio. If the ratio is based on the next 12 months of expected earnings, this ratio is called a forward, expected, or projected P/E ratio. There is also a hybrid of the two methods.
Now that we have the price to earnings ratio, what is next?
What the P/E Ratio Can Tell You
You can analyze the P/E ratios of industry groups to find out which are hot and expected to grow and which are not. If the gold mining industry has a P/E of over 50 but auto manufacturers are only at P/E ratio of 10, this may give you a quick clue as to troubled and booming sectors of the economy, or at least which are growth areas.
As well, you can look within an industry group and see which stocks have the highest price to earnings ratio and which have the lowest. Compare this to the industry average for an idea of where that particular stock falls in the valuation bell curve. P/E is very useful for showing up stocks that are relatively high priced or low priced as compared to its industry group.
The rule of thumb is that high growth industries will have higher P/E ratios while stable but low income stocks will have lower P/E ratios.
Price to earnings ratios has a large amount of variance but in general 6 is low and 50 getting high. Depending on your strategy the P/E numbers can be used to screen for stocks. Here are a few ways it can be used:
- Screen for high P/E shares to find volatile stocks with high growth potential
- Screen for low P/E shares to find potentially undervalued stocks
- Screen for the highest and lowest P/E stocks with in an industry group to find potentially under and overvalued stocks.
Still, this can be a lot of work to screen for P/E ratios and then try to manually compute this against the expected growth. Is there another ratio to help us determine if the price to earnings ratio is high or low compared to future growth forecast? Let's welcome the PEG ratio.
PEG Compares Price to Earnings Against Growth
Another ratio was devised as a derivative of the P/E ratio to assess if the stock was under or over valued as compared to its future growth. This can be a difficult task to perform manually. With the help of the PEG ratio this task is effortless and easy.
The Price to Earnings to Growth (PEG) ratio is an easily tabulated number to indicate relative worth. Simply divide the price to earnings by the annual expected growth.
- A company with a P/E of 50 and with annual expected growth over 5 years at 25 percent has a PEG is 2.
- A company with a P/E of 10 and expected growth of 10 percent has a PEG of 1.
- A stock with a P/E of 15 but with anticipated growth of 30 percent per annum has a PEG of 0.5.
| PEG less than 1 | Undervalued or Market Expectation is Lower than Analysts |
| PEG of 1 | Fairly valued |
| PEG of more than 1 | Overvalued or Market Expectation is Higher than Analysts |
A low PEG could mean an undervalued stock. But remember that the ratio is based on analyst estimates of future growth. What if the analysts were wrong and the growth was much lower? Than the "true" PEG ratio would be not nearly as lucrative. Keep in mind that a low PEG could be a good value pick or it could mean the analysts are wrong and the market knows it.
Of course, there is much more to it than simply screening for stocks with a PEG of less than one. But this does provide a good basis for finding stocks with a low P/E ratio related to the expected growth.
How to Use the PEG Ratio
Keep in mind a few of the following pointers when screening for low or high PEG ratios.
- PEG ratios do not consider dividends. A stock might have a high share price as compared to its growth, but will shed much value when dividends are paid out. For this reason, PEG ratios are best used with low or no dividend paying stocks.
- PEG ratios do not give a fair evaluation of blue chip or very slow moving stocks. If you are interested in strong, well established and stable shares that rise very slowly over time, the PEG ratio might be misleading. For instance, a mammoth stock might have assets of 10 dollars per share with an identical share price. If earnings were only 50 cents per year this would give the stock a P/E of 20. If the growth was only 5 percent per year the PEG would be 4, seeming to be highly overvalued. Before you short the stock, try to find out what it's worth. With 10 dollars per share in asset value, this stock might remain stable at these prices no matter what the growth expectations are.
Knowing the P/E and the PEG are two important ratios that are based on earnings per share. These ratios can tell you the relative valuation of a stock as compared to its industry, the market, and its own future growth. However, what if we are interested in determining absolute values of stocks based on what the company owns or has in assets? Shouldn't a company with a large amount of assets be worth more than an Internet based business that has none? Doesn't intrinsic value play a role?
It does and we will learn more about this in Book Values.