Online Investing Hacks

Calculate Additional Valuation Ratios

Finding good companies is only half the battle; buying them at the right price is the other. A number of valuation ratios help you figure out if the price is right.

Although the P/E ratio can help you determine a stock’s value, it can sometimes be misleading, particularly for companies that have recently issued a warning about their future earnings. Investors might have bid down the price of the stock based on those lowered expectations, resulting in an abnormally low P/E ratio for that company. In such a case, a low P/E ratio doesn’t reflect the true value of the company based on its future growth. On the other hand, companies that grow very quickly often have extraordinarily high P/E ratios. However, if those companies can continue to grow at the same pace, the rapid increase in earnings over time brings those P/E ratios back to more common values. Other valuation ratios can confirm or challenge the value shown by the P/E ratio.

P/E to Growth Ratio

The P/E to growth ratio (PEG) is an indication of whether a company’s growth can support the high P/E ratio that the stock price carries. The PEG ratio, shown in Example 4-15, compares a stock’s current P/E ratio to its expected future EPS growth rate.

Example 4-15. Formula for the PEG ratio

PEG Ratio = (P/E Ratio) / % EPS Growth Rate

For long-term investors, it’s best to look at EPS growth rate estimates as far in the future as possible. For example, you can find five-year analyst EPS estimates at ...