With so many valuation methods available for investors, it may sometimes be a daunting task to try and find which metric we should focus on. Benjamin Graham, well known as the father of value investing, was a keen believer in using price to book value as a method to find undervalued stocks. This proved to be a great method of finding stocks that had hidden value within its balance sheet. Warren Buffett, the second wealthiest person in the world, said that a company’s ideal valuation should be a sum of the discounted value of the future total cash flows of…
With so many valuation methods available for investors, it may sometimes be a daunting task to try and find which metric we should focus on.
Benjamin Graham, well known as the father of value investing, was a keen believer in using price to book value as a method to find undervalued stocks. This proved to be a great method of finding stocks that had hidden value within its balance sheet.
Warren Buffett, the second wealthiest person in the world, said that a company’s ideal valuation should be a sum of the discounted value of the future total cash flows of its operations. The method of valuation, called the discounted cash flow model, has been used to estimate a company’s value.
Yet, both these methods used in isolation have its downfalls. Book value may not take into account the profitability of a business. For companies that have high returns on equity, a price to book value method may understate the company’s true value. Meanwhile, discounted cash flow models require estimations of future cash flows and discount rates that are highly variable in nature.
Having said that, one valuation metric that may be much simpler, and more appropriate for retail investors to concentrate on is the Price to Earnings Growth (PEG) metric. Renowned investor Peter Lynch touted this metric as a key fundamental to looking for companies that can outperform the market. With this in mind, let us break down how this metric works.
Price to Earnings multiple
Before we look at the price to earnings growth ratio, it is important we understand first the basic price to earnings ratio.
Most investors will be familiar with the price to earnings (P/E) ratios that are readily available on stock screeners.
To calculate the P/E ratio of a company, we can simply divide the price per share over the earnings per share of a company.
It is illustrated below:
P/E ratio = Price per share / Earnings per share
A simple example would be if company A is trading at $10 per share and has an earnings per share of $1, its P/E ratio would be 10.
A lower price to earnings multiple means the company is trading cheaper in relation to its earnings. However, it is important that investors be warned against relying on P/E ratios shown by stock screeners as they can sometimes be distorted by one-off earnings that should be removed from the calculations. As such, investors may be better off manually calculation P/E ratios of a company to get a better picture.
P/E Growth ratio
The P/E growth ratio or PEG ratio goes one step further by including earnings growth into the equation.
It can be calculated as follows:
PEG = PE / earnings growth
A lower PEG ratio means that a company is trading cheaper relative to its earnings growth and current earnings.
Company B is trading at $10 per share and earnings of $1 per share. It is expected to grow at 10% annually in the next five years. Therefore, it would have a PE ratio of 10 and a PEG ratio of 1.
Company C, on the other hand, is trading at $10 per share and earnings of $1 per share. However, it is expected to have 20% growth per year in the next five years. It, therefore, has a PEG ratio of 0.5.
In this example, company C has a much lower PEG ratio due to its higher growth expectation.
The Foolish bottom line
There is no one-size-fits-all valuation metric to accurately estimate a company’s true value. However, the PEG ratio may be the easiest metric that gives an investor an idea of the company’s worth based on current profits and earnings potential.
As always, there are other aspects of a business that we need to consider before making an investment decision. Having said that, looking out for companies with a PEG ratio less than one may be a good way to screen for stock ideas.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.