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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.

Now let’s look at a real world application to drive this point home. We’ll compare Best Buy (BBY) and Apple (AAPL), two stocks in the retail technology sector (All data taken from Google Finance as of September 13). Best Buy is priced at $23.07 and has a forward-looking EPS of $3.31, which gives the company a leading P/E of 6.97. Apple is priced at $387.02 and has a forward-looking EPS of $27.47, implying a leading P/E of 14.09. This means that you are paying more than double for the earnings of Apple relative to the earnings of Best Buy. Then why is there so much positive hype surrounding Apple, while at the same time, investors having been dropping Best Buy like a ton of bricks? The answer lies in the growth prospects of the two companies. Apple has been on a decade-long hot streak, increasing its price from a mere $24.75 a share on January 7, 2000 to almost $400 today! Apple has released some of the most revolutionary products during this time, such as the IPod, IPad, and IPhone, and continues to innovate even in the face of adversity. Best Buy, on the other hand, has seen its share price cut into almost a third over the last five years. They have lost significant sales as many consumers have shifted from physical purchases to online alternatives. Best Buy recently reported a 30% drop in quarterly profit.

Now, we will factor in the long-term growth estimates. I’ve used the mean value of analysts’ estimates for long-term growth for each company, attained from the Reuters section of Google Finance. Apple has a long-term growth rate of 20.85% and consequently a PEG ratio of 14.09/20.85 = .656. Best Buy’s long-term growth rate is 9.26%, giving them a PEG ratio of .753. As discussed above, a lower PEG ratio implies a higher relative value. Therefore, despite having a significantly higher P/E ratio, Apple appears to be priced at a bargain relative to Best Buy.

I picked Apple and Best Buy, two stocks headed in opposite directions, to prove my point in the most concise way possible. When using the PEG ratio in your analysis, you may have two stocks that are a little more comparable than the two I’ve chosen. The differences in valuation will probably be much more subtle.

I would just like to stress that my reasoning for writing this article is certainly not to convince you that I’ve found a way to find the better buy of several stocks by simply calculating a ratio for each. I will, however, stress that the PEG ratio can be a helpful tool when analyzing several stocks for hidden value. There are no shortcuts here. I am a firm believer that full analysis should be done on stocks – economic and industry trends, competition, ability to repay long/short term debt, sales and profit trends, discounted cash flows, etcetera. The PEG ratio is a great additional step to the above mentioned analyses and can help you reach a rational and informed investment decision.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.