Value investors have a strong focus on stocks with a low valuation compared to its expected earnings. A very popular tool for investors to identify an undervaluation is the P/E ratio.
The P/E ratio often looks cheap but they are cheap for a reason. Mostly a dying operating business is responsible for the low P/E. On the other side, a high P/E could show that we have to deal with a high-growth company.
This general problem could be solved with the PEG ratio. By definition, it describes the value compared to its growth or Price-Earnings-To-Growth Ratio.
The P/E ratio is simply: Price / Earnings
Essentially, this tells you how much an investor is willing to pay for each unit (year) of earnings. If a stock is trading at a P/E ratio of 30, it is said to be trading at 30x times its annual earnings.
In general, the lower the P/E ratio the better. A common threshold for many investors is a P/E of 20 or less. (For the record, at the time of this writing, the S&P 500 Index was trading at a P/E (using F1 Estimates) of 15.33.)
A PEG ratio is the: P/E Ratio divided by the Growth Rate
Conventional wisdom says a value of 1 or less is considered good (at par or undervalued to its growth rate), while a value of greater than 1, in general, is not as good (overvalued to its growth rate).
Many believe the PEG ratio tells a more complete story than just the P/E ratio. (The S&P at the time of this writing had a PEG ratio of 1.93.)
Let's take a look at both of these in action.
For example: a company with a P/E Ratio of 25 and a Growth Rate of 20% would have a PEG ratio of 1.25 (25 / 20= 1.25).
While a company with a P/E Ratio of 40 and a Growth Rate of 50% would have a PEG Ratio of 0.80 (40 / 50= 0.80).
Traditionally, investors would look at the stock with the lower P/E ratio and deem it a bargain (undervalued). But looking at it closer, you can see it doesn't have the growth rate to justify its P/E.
The stock with the P/E of 40, however, is actually the better bargain since its PEG ratio is lower (0.80) and is trading at a discount to its growth rate.
In other words, the lower the PEG ratio, the better the value. That's because the investor would be paying less for each unit of earnings growth.
So which one is better?
They both have their usefulness. I do like how the PEG positions the P/E ratio in relation to its growth rate to put everything into perspective.
Quite frankly, I use both, so I'm going to say it's a tie. Plus, you couldn't even create the PEG ratio without the P/E.
Attached you can find the 20 cheapest dividend growers by PEG and P/E. The results include only stocks with a constant dividend growth history of at least 10 years. They are classical Dividend Achievers.
Here are the results:
|20 Cheapest Dividend Growth Stocks By PEG (click to enlarge)|
|20 Cheapest Dividend Growth Stocks By PE (click to enlarge)|