If your mom sends you on an errand to buy her 10 pencils. On reaching a shop that sells pencils, you have two options.
The first option is to buy 10 pencils separately for $120. That is, 1 pencil cost $12.
The second option is to buy a packet for $100. A packet contain 10 pencils.
What will you buy? The packet of pencil that contains 10 pencils for $100 or you will buy 10 pencils separately for $120.
Any smart person will buy the packet of pencil.
Lets assume $12 is cheap for a pencil.
The PEG ratio answers the question. Yes 1 pencil is cheap at $12. But how cheap is it when in bulk form.
The P/E ratio should not be used in isolation. The PEG ratio puts the earnings growth into perspective.
A PE ratio might seem cheap but when you include annual earnings growth to your calculation, it can tell better how cheap the stock is.
As an investor you don’t want to put your money in a company with no good prospect for its future earnings growth. As a company’s earnings grow your Return On Investment appreciates. This is why investors pay attention to PEG ratio.
PEG is an acronym for Price to Earnings Growth.
PEG ratio is price to earnings ratio divided by the annual earnings growth per share.
PEG = Price to earnings ratio/ Annual earnings growth per share
Assume company A has a P/E of 9 and has an earning growth of 32%.
Company B has a P/E of 10 and has an earning growth of 19%.
Company A will have a PEG of 0.63 and company B has a PEG of 0.55
What does this tell you? Though company A has a lower PE ratio than company B.
A value investor will go for company B because it has a lower PEG ratio.
A GARP investor will go for company A because of it has higher earnings growth and its PEG ratio is lower than 1.0
A good rule of thumb is that a stock with a PEG ratio lower than 1.0 is an undervalued stock.