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Here’s how to use the PEG ratio to tell if a stock is overvalued relative to its growth
The PEG ratio (Price/Earnings to Growth) ratio is a useful way to tell if a stock is overvalued compared to its growth.
In this article, we outline what the PEG ratio is and how investors can use it.
We also outline an alternative to the PEG ratio – the EV/EBITDA to EBITDA growth multiple – that operates similarly and can be another way for investors to tell if a company is over or undervalued.
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The P/E multiple is limited
The most common multiple used to value a company is the Price/Earnings (P/E) multiple which compares a company’s share price to its EPS.
Investors may determine a company is over or undervalued by comparing one company’s P/E to competing companies, or the average P/E for companies in an index.
One major criticism of the common Price/Earnings (P/E) multiple is that does not take into account future earning potential of the company.
Well, it actually does, but it does not tell if a company is overvalued compared to that growth. The PEG ratio solves this problem.
How the PEG ratio works
The PEG ratio is calculated by dividing a company’s P/E multiple by the EPS growth rate that is expected in the relevant year.
So if a company has a P/E multiple of 15x and a long-term growth rate of 20%, the PEG ratio would be 0.75x.
As a general rule, a company with a PEG ratio below 1 is undervalued while a company with a PEG ratio above 1 is overvalued.
Challenges with the PEG multiple
Obviously, the challenge with the PEG ratio is deciding an appropriate growth rate.
As an individual investor, you could use consensus estimates for EPS growth, or you could use your own forecasts.
There is also the risk that one or two years of high growth might overstate the company’s potential, while one or two years of low or no growth might underestimate the company’s potential.
EV/EBITDA-to-EBITDA-growth is an alternative to the PEG ratio
At Stocks Down Under, we have conceived an alternative multiple – the EV/EBITDA-to-EBITDA-growth multiple.
The difference is that instead that you use EV/EBITDA instead of P/E and EBITDA growth as a growth rate.
See this article for more explanation about EBITDA and how it works.
Once again, a company with a multiple greater than 1x could be overvalued, but a company with a multiple below 1x could be undervalued.
Multiples such as the PEG ratio are only a guide
Ultimately, multiples should only be one item in an investors’ toolkit for valuing businesses.
Investors need to look at all 3 of a company’s financial statements, its management, its market position, its track record and its growth plans for the years ahead.
They may also wish to consider a DCF approach or a transaction-based approach when it comes to putting a specific price on the company.
This being said, multiples such as P/E and EV/EBITDA, used in conjunction with the PEG ratio and EV/EBITDA-to-EBITDA-growth multiple, can be good starting points to determine what a company should be worth.
From there, investors can potentially identify would-be investment opportunities, as well as companies to stay clear of.
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