There are many factors that might cause a stock’s price to rise, including a positive news report, an uptick in the industry as a whole, the perception of undervaluation based on historical fundamental data, and trading by technical analysts based on bullish price and volume patterns.
If a stock’s price has risen dramatically, it should be because of strong revenue and earnings growth. Can we tell whether or not a company’s valuation is fair based just on its projected rate of growth? Naturally, that’s not the case. The stock price, in relation to the anticipated growth of the company, is another important indicator.
In this article, I’ll discuss the drawbacks of focusing on either a company’s growth potential or its P/E ratio alone, before moving on to the PEG ratio, which combines these two metrics into a single, more actionable one (Price to Earnings Dividend by Growth).
Investment in high-growth stocks and earnings projections
Analyst coverage is often provided to stocks once their market cap reaches $500 million. The standard for such reporting is a rating and an earnings forecast. Weak buy, neutral, moderate sell, strong sell, and strong buy are all possible ratings.
In order to make a profit projection, one must calculate the expected net profit per share. In addition to quarterly and annual projections, analysts will often project earnings growth rates out to five years.
Looking for companies with exceptionally high 5-year projected earnings growth rates is a simple way to identify high-growth equities. It is with this expected profit that the PEG ratio will be calculated.
Do we have any other tools at our disposal besides analyst forecasts to search for high-growth stocks? Of course, and they’re especially appreciated by tiny businesses that can’t afford to make long-term plans.
Investigate Past Earnings Growth
Profit increase over prior years and quarters can be examined in this way. A company’s bottom line may continue to expand at a 20% yearly rate if it has done so for the past several years. It’s also possible to look for fast-developing markets.
Can we anticipate a growth in the use of renewable energy sources? When will oil and silver prices stabilize? You can use your findings to find small businesses that have significant exposure to the commodities or industry trends you’ve identified.
Despite exceptions, it is generally true that smaller businesses have easier difficulty attaining rapid expansion.
As a matter of fact, doubling a hundred dollar amount of income or earnings is a lot less difficult than doubling a hundred million dollar amount. However, Apple has shown that even very large organizations may experience rapid expansion.
With that in mind, here are a few firms and the analyst estimates upon which the PEG ratio is based:
- It is predicted that International Coal Group’s (NYSE: ICO) earnings will increase by 77% each year over the next five years.
- Over the next five years, analysts predict that Comtech Telecommunications Corp. (NASDAQ: CMTLannual )’s earnings will expand by 35% per year.
- Investors anticipate 30% yearly growth in SIRIUS XM Radio (NASDAQ: SIRI) for the next 5 years.
If one were to rely just on this information, one may assume that ICO is the best high-growth company to acquire, followed by CMTL and SIRI in close succession. But could we be overlooking something vital?
Now that we have the earnings growth forecast, how do we evaluate whether or not the current share price is reasonable? Should I invest in the high-growth stock now?
Price to Earnings Ratio Relative Value
How do you tell if the price of your stock reasonably reflects its potential earnings? In order to find out, just conduct a quick calculation. The P/E ratio measures the cost of an investment relative to its potential return.
Divide the current share price by the earnings per share to get an idea of how much the price has increased over the past year relative to the company’s annual profits.
Let’s first determine the PE ratio for the aforementioned stocks and then examine its significance.
- ICO has a price of $10.85 per share. It has earned 15 cents per share. $10.85 / 0.15 = price to earnings ratio of 72.3. The share price is trading 72.3 times higher than its earnings.
- CMTL has a price of $26.72 per share. It has earned $2.42 per share. $26.72 / $2.42 = price to earnings ratio of 11.04. The share price is trading 11.04 times higher than its earnings.
- SIRI has a price of $1.66 per share. It has earned 1 cent per share. $1.66 / 0.01 = price to earnings ratio of 166. The share price is trading 166 times higher than its earnings.
Which conclusion may we draw from this P/E ratio? To determine whether a stock’s P/E is expensive or cheap compared to its peers, we can look at the stocks’ P/E ratios.
Since the value of a business is predicated mostly on its expected future growth rather than its present cash flow or assets, stocks with better growth potential typically trade at higher multiples than value stocks with fewer future growth opportunities.
Therefore, we can’t rely just on the P/E ratio to inform our investment decisions. We need to evaluate the P/E ratio of a stock to its growth potential in order to determine whether or not it represents a worthwhile investment opportunity. What criteria shall we use to make this comparison? PEG ratio is useful in this context.
Overview of the PEG Ratio
How do we value companies using the PEG ratio, and what exactly does that abbreviation stand for? Simply said, the PEG ratio is the price-earnings ratio (P/E ratio) divided by the earnings-growth forecast.
The average annual growth rate over the past five years is used to predict future growth although the average annual rate over the past three years, your own projections, or the company’s earnings guidance could also be used.
To calculate:
- ICO has a PE of 72.3 and an expected growth of 77% per year. The PEG ratio is 0.94.
- CMTL has a PE of 11.04 and future growth expectations of 35% annually. The PEG ratio is 0.32.
- SIRI has a PE of 166 and future growth expectations of 30% annually. The PEG ratio is 5.53.
This ratio gained widespread acceptance thanks to the work of Peter Lynch, a famous stock investor on Wall Street and author of the book One Up on Wall Street. Just how does this ratio help us determine if a growth stock is priced fairly?
Any company that is reasonably valued will have a P/E ratio that is equal to its growth rate, according to Lynch. So, if the PEG ratio is 1, the price is equal to the growth rate. It is cheap if it falls below 1, and expensive if it rises beyond 1.
PEG ratios indicate that CMTL is significantly undervalued, ICO is well valued, and SIRI is significantly overvalued. Is it really that easy to locate growth stocks, or should we keep in mind anything else?
The PEG Ratio’s Key Points
It would seem easy to just look for companies with low PEG ratios and buy them all, but there are several drawbacks to this strategy that you should be aware of.
1. Data will be skewed by extremely low annual incomes.
If, after five years, the company is projected to increase its annual profit from $0.001 to $0.0010, its growth rate will have been 900%, or 180% a year.
Despite the impressive rate of growth, a 9-cent rise in earnings per share pales in comparison to a corporation that doubled its profit from $1 to $10. Care must be taken to avoid unfairly benefiting penny companies by setting too low of a PEG ratio threshold.
2. Expected earnings predictions serve as the foundation for the PEG valuation.
When it comes down to it, can we trust this corporation to deliver? There is no way to tell for sure. The empirical evidence suggests that the volatility of high P/E growth stocks increases along with their earnings.
This complicates the already-tough task of making an accurate prognosis. In this case, the PEG ratio should be interpreted with caution because the forecast is not very solid.
If your business has the potential for rapid expansion, how can you evaluate its prospects? While there’s no foolproof way to tell, you can evaluate if they’re capable of record-breaking expansion by examining their earnings growth rates in the past.
Keep in mind that the company’s rapid expansion in the past is no guarantee of continued expansion in the future, but it does indicate whether or not the company has demonstrated the potential to expand rapidly in the past.
3. Always conduct thorough research into the risk of a stock with a low PEG ratio.
Is there a connection between the high risk and the huge possible reward? Or, perhaps the PEG ratio will change drastically because, despite the high 5-year prediction, earnings are likely to drop dramatically over the next year.
To illustrate, if earnings were to decline over the next year, the P/E ratio and your PEG ratio would likely both increase, reducing the attractiveness of the stock’s value.
To be sure that you are not setting yourself up for short-term financial distress, have a look at your forward P/E ratio, which is based on an estimate of your earnings for the following year.
To illustrate, say you had a trailing P/E ratio of 30% and a long-term growth rate of 30%, yielding a PEG of 1. But you’ve seen that this coming year is predicted to be disastrous, with earnings decreasing by a factor of two.
Thereafter, they’ll get back on track and achieve that 30% expansion rate. Assuming no change in prices over the next year, your P/E ratio will be 60% and your PEG ratio would be 2, for a considerably more aggressive long-term growth rate of 30%.
To rephrase, ensure sure the PEG ratio is not artificially low and is predicted to climb soon owing to a short-term decline in earnings.
4. Ensure that a stock is being covered by a few trustworthy analysts at the very least.
In an ideal world, earnings estimates would be made by a large number of different analysts and would show little variation, indicating strong growth. Earnings that have not exceeded expectations indicate that their projections are on the money.
A high-quality stock is more likely to succeed if analysts’ predictions are consistent and their margin of error is small. For instance, 8 industry experts predict that ICO will post earnings of $0.78 to $1.80 per share this year. On top of that, analysts have been consistently off by an average of 74% over the past four quarters.
Consequently, it is difficult to base choices on the broad variation in analyst estimates and the low accuracy rate. Finally, in the absence of analyst coverage, you can use the company’s own projections for its future earnings, provided the company has a track record of being reliable in its projections.
Bottom Line
To find high-growth firms that are nonetheless reasonably priced, the Price/Earnings to Growth (PEG) ratio is a useful screening tool. However, you should be cognizant of the fact that it is only a tool. You should never use a single ratio to quickly examine firms without first completing some research.
There are a number of qualitative aspects to evaluate, such as the company’s business plan, its track record of success, and its standing in the industry. The PEG is a powerful tool that, when applied correctly, may help you locate high-growth equities that are also reasonably priced.
Please explain how you have applied the PEG ratio in order to identify profitable high-growth stocks. Explain what you learned the hard way, and what worked for you.
