How do you assess stock quality based on PEG and PE ratios?

New Delhi: Do you rely on eating apples alone to secure good health? Surely, an apple a day keeps the doctor away but this does not mean that you eat nothing but apples. You must focus on overall nutrition too. This is true for those looking to create an all-around healthy investment portfolio. To build a healthy portfolio, you need to value a company on more than just the P/E ratio that drives its valuation. Also important is the PEG ratio, which calculates the company's growth potential.

Understanding PEG ratio

The PEG ratio, also known as the price-to-earnings-to-growth ratio, is a valuation statistic that determines a stocks' relative value based on its price-to-earnings (P/E) ratio and the stock's expected growth rate. Dividing a company's P/E ratio by its earnings growth rate. The score reflects how much an investor is willing to pay for the company's expected future growth relative to its current earnings.

In discussing its implementation, note that a PEG of 1 indicates the stock is reasonably priced, a PEG less than 1 indicates the stock may be undervalued, and a PEG above 1 indicates that the stock may be overvalued.

For example, if a company has a P/E of 20 and expects growth in 10 years, its P/E is 2 (20/10). This suggests that the investor is paying twice the company's earnings growth rate for the stock, which could indicate that the stock is overvalued.

Distinction between PEG and PE ratios

The five distinctions between PEG and PE ratios are as follows:

Formula

Remember that the PEG ratio is derived only using the PE ratio, which is calculated by dividing a company's current stock price by its earnings per share (EPS).

Approach

The most important difference between the two is that the PE indicator shows only the past elements of the organization while the PEG indicator helps you to identify both the historical aspects and the future development of the company.

Valuation

The PE indicator identifies whether stocks are under or overvalued based on their current earnings, while the PEG indicator compares companies with different growth rates and identifies which trade is better.

Comparison

While the PE ratio can be used to evaluate companies in the same industry, the PEG Index is better suited for comparing companies with different growth rates or in different industries.

Limitations

While the PE and PEG ratios can be useful, they should not be used in isolation and should be read in conjunction with other financial data such as the company's debt levels, cash flow, and industry trends. Furthermore, if earnings growth rates are difficult to anticipate or if the company has a high debt load that may limit its potential to grow, the PEG ratio may be less trustworthy.

It can be a useful tool for you as it takes into account both current earnings and the projected growth rate, giving you a more comprehensive picture of the company's value. However, it is important to remember that the PEG indicator should not be used on its own, but in conjunction with other fundamental analysis and assessment tools.