# A Valuation Tool That Is Easily Calculated Yet Too Often Overlooked

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by: Efficient Alpha

By Mario Mainelli

The observed price earnings ratio, more commonly referred to as the P/E ratio, is one of the most popular valuation tools used by investors. The concept is simple and intuitive: the ratio compares the amount of money you are paying for the earnings of the company. A high P/E ratio would imply that you are paying more for the amount of earnings you are receiving. You may conclude that if you have two companies with the same earnings and operate in the same industry, but one has a significantly lower P/E ratio, you should purchase the one with the lower P/E ratio. Why spend more for the same amount of earnings, right? While it may seem logical to go with the company with the lower P/E, this is not always the best choice.

You should try to determine the reason why the stock is priced higher. If it is simply overpriced, then you should most certainly choose the company with the lower P/E. However, the stock with the higher P/E may be priced higher because it has better growth prospects. The stock with the higher P/E ratio may indeed be relatively undervalued when taking into account the potential for growth in sales and/or earnings. For this reason, the price earnings to growth ratio, or PEG ratio, is a more effective valuation tool. Stocks with a lower PEG ratio are considered relatively undervalued.

At this point, I’d like to add in some theory on how to calculate growth for those of you that like that sort of thing. Sustainable growth, the amount of growth a company can attain for the foreseeable future, can be calculated by multiplying return on equity (ROE) by retention of earnings (b):

g = ROE x b.

ROE is calculated by dividing Net Income by Equity. Anybody familiar with the DuPont model knows that ROE can be extended to Net Profit Margin (Net Income/Sales) multiplied by Asset Turnover (Sales/Assets) multiplied by Leverage (Assets/Equity). This can be further broken down, but we can stop here for the sake of simplicity. We can now define sustainable growth as follows:

g=[(NI/Sales)(Sales/Assets)(Assets/Equity)] x b.

The sustainable growth formula above is a great proxy, but must be taken with a grain of salt. There are certainly other factors to consider when determining a sustainable growth rate, such as economic and industry trends, comparative/competitive advantages, and potential future opportunities. When calculating PEG, it may be best to use an estimate based on the mean value of numerous analysts. This is available under the Reuters Financials section of Google Finance for just about any stock and should be a fairly accurate prediction. If you really feel comfortable with financial modeling and analysis, you can also use the sustainable growth formula and adjust it yourself for any factor you deem necessary.