# Using the PEG Ratio to Find Hidden Stock Gems

The price-to-earnings ratio (P/E) is a popular way for investors to measure the relative valuation of two stocks. It tells investors how much Wall Street is willing to pay for every $1 in company earnings. In general, a lower P/E is considered better because it suggests that the price is backed up by fundamentals, rather than speculation.

One of the limitations of P/E is that it doesn’t factor in growth in underlying earnings. Back when Sam Walton first began opening Walmart stores throughout the United States, Walmart's P/E at the time failed to account for the growth potential in the investments in expansion. If an investor were to acknowledge growth, they would've realized that Walmart was one of the cheapest stocks available on a value basis. The future cash flows more than justified the stock's level of valuation.

To make up for this shortcoming in P/E, investors began using the price-to-earnings-to-growth ratio, or PEG.

## Calculating the PEG Ratio

To calculate the PEG, an investor must first calculate the P/E. Let's say stock for the hypothetical company ABC is trading for $20 with an earnings per share (EPS) of $1.50. To calculate that stock's P/E, simply divide the price of $20 by the EPS of $1.50, giving you a P/E of 13.33.

Though not necessary for calculating the PEG, you can also invert this P/E ratio to calculate something known as the earnings yield. For this example, that would give you an earnings yield of 0.075, or 7.5% (1 ÷ 13.33 = 0.075). This figure makes it easier to compare shares of a company to investments like bonds or real estate.

Once you have the P/E, you simply divide that by the growth in earnings per share to arrive at the PEG ratio. Like P/E, a lower PEG is generally considered preferable to a higher PEG.

Let's stick with the ABC example. You know that conservative estimates expect company ABC to grow 3% in the next year. Now, compare ABC stock to the stock for company XYZ, which trades at $60 per share with an EPS of $4 and expected annual growth of 5%. Which stock is cheaper? By calculating the PEG ratio, you can find out.

Company ABC's PEG would be calculated like this:

- $20 stock price divided by $1.50 EPS gives you a P/E of 13.33
- P/E of 13.33 divided by 3% growth gives you a PEG of 4.44

Compare that to Company XYZ's PEG:

- $60 stock price divided by $4 EPS gives you a P/E of 15
- P/E of 15 divided by 5% growth gives you a PEG of 3

In this case, XYZ appears cheaper at $60 per share than ABC does at $20 per share, despite having a higher P/E ratio. Notice that, for PEG calculations, the growth figure is kept as a whole number, rather than converted to decimal form.

## Resist Optimism While Using the PEG Ratio

The biggest danger in using the PEG ratio to find cheap stocks comes from being overly optimistic. Growth estimates are just that—estimates. Using the most conservative figure available helps avoid overpaying for a stock that doesn't deliver on growth expectations. By banking too much on the promise of the future, a stock that would otherwise be worthless might appear to be a great bargain.

When investors as a whole become overly optimistic, this creates a stock market bubble—like the dot-com and housing bubbles that "popped" in 2000 and 2008, respectively. When investors realize that their optimism allowed stock prices to rise too high, those bubbles burst with sudden stock crashes.

## Get More Specific With the Dividend-Adjusted PEG Ratio

A simple PEG ratio works best for companies that don't offer dividends. However, many stocks *do* come with dividends, especially when it comes to major corporations and blue-chip stocks. Those dividends cut into the company's true EPS.

If the stock you're watching offers a dividend, you might prefer to use a dividend-adjusted PEG ratio. Calculating it requires just a slight adjustment to the standard PEG ratio formula. Instead of simply dividing the P/E by the expected earnings growth, you first add together the expected earnings growth and dividend yield. You then divide the P/E by that figure.

*The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.*