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The PEG Ratio

The Price/Earnings to Growth Ratio (PEG) is a tool that can help investors find undervalued stocks. It is not as well known as the Price per Earnings Ratio (P/E) and Price per Book Ratio (P/B) but it is just as valuable.  It gives us some perspective of the growth potential in relation to its EPS growth. The PEG ratio compares a stock's P/E ratio to its expected EPS growth rate. If the PEG ratio is equal to one it means that the market is pricing the stock to fully reflect the stock's EPS growth. In theory this is normal because the P/E is supposed to reflect a stock's future earnings growth in a rational and efficient market. 

If the PEG ratio is greater than 1 it indicates that the stock is possibly overvalued or that the market expects future EPS growth to be greater than what is currently in the Street consensus number. Most stocks will have PEG's greater than 1 and this is an indicator that most stocks in the market are grossly overvalued.  Why Because as we often stress stock prices move far ahead of events and the news gets priced in the stock in advance.  Growth stocks typically have a PEG ratio greater than 1 because investors are willing to pay more for a stock that is expected to grow rapidly (otherwise known as growth at any price). 

In the rare event that a PEG ratio is less than 1 it could be view in two ways. On one hand value stocks usually have a PEG ratio less than 1 because the stock's earnings expectations have risen and the market has not yet recognized the growth potential. On the other hand it could also indicate that earnings expectations have fallen faster than the Street could issue new forecasts.  A stock could be possibly undervalued which could mean the market has missed it.  Or it may be priced that way for a reason. The stock has moved down in advance of some possible bad news.  That is the market does not expect the company to achieve the earnings growth that is reflected in the Street estimates. 

It is important to note that the PEG ratio cannot be used in isolation. As with all financial ratios investors using PEG ratios must also use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company's operating trends fundamentals and what the expected EPS growth rate reflects. Additionally to determine if the stock is overvalued or undervalued investors must analyze the company's P/E and PEG ratios in relation to its peer group and the overall market

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