Ask Matt: What does PEG ratio tell investors about stocks?
— -- Q: What is a PEG ratio and what does it tell investors about stocks?
A: When stocks start rising, and valuations increase, investors start looking for ways to justify the higher price tags.
Traditional measures, such as price-to-book value and price-to-earnings ratios, are often replaced in the minds of investors with other metrics. One measure investors start hearing more about during times of rising stock prices is the PEG ratio.
The PEG ratio is essentially a mash-up of two other popular measures: the price-to-earnings ratio (P-E) and a company's earnings growth rate. Believers in the PEG ratio think that the P-E by itself is of limited value. Some companies are more expensive, or have higher valuations, than others. But that higher price tag may be worthwhile if the company is growing more rapidly, these people say.
The PEG ratio is a way to quantify this mindset. The PEG is calculated by dividing a stock's P-E ratio by its expected growth rate. Stocks with a low PEG ratio are thought to be undervalued, while stocks with high PEG ratios are thought to be expensive.
The traditional rule of thumb is that stocks with a PEG ratio below 1 are cheap and should be considered because their P-E is less than their annual growth rate. Similarly, stocks with PEG ratios of more than 1 are expensive and should be avoided.
There's much debate about how valuable of a tool the PEG ratio is. You can read an exhaustive examination of when and how the tool works in this examination by Portfolio 123's Mark Gerstein.
It's certainly an indicator investors consider, and if the stock market continues to rise, expect to hear it come up more frequently.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies and Fundamental Analysis for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Follow Matt on Twitter at: twitter.com/mattkrantz
