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Every seasoned investor will use this common practice of price to earnings ration also known as price multiple or P/E ratio to determine whether the company’s stock is undervalued or undervalued. So this usually means that companies with a high P/E ratio are those that are typically growth stocks. This however is not entirely true as their relatively high multiples do not always mean that the stocks are not good buys for the long term and that the stocks are overpriced. The P/E Ratio is the market value per share divided by the earnings per share (EPS). 

From the formula that was presented earlier, it is obvious that there are two primary components that are working here. One of them is the market value or basically the price of the stock while the other one is the company’s earnings.

For a company as well as for investors to consider that company seriously when wanting to invest, earnings is one of the factors that are taken into deliberation. This is because the earnings of that company represents why companies go into business in the first place which is to make profits. And earnings can be calculated by taking the hard figures into account which will include the salaries, revenue, rent, cost of goods sold (COGS) and so on. All these factors are taken into consideration as they are important to the livelihood of the company. Problems will arise eventually when the company is not utilizing its resources to its optimum to gain positive earnings.

Other factors to take into consideration besides earnings include:

• Expectations – When you are interested in a certain stock and want to purchase it, you have high expectations for it to make strong profits. You are however less interested in the stocks past achievements. That is why the stock exchange is always forward looking.
• Brand – Sometimes the value of a certain company or brand resides with the brand. Some brands are worth billions compared to the company that produced it.
• Barriers To Entry – One of the strategies that some companies use, so that they can remain successful in the long run is to keep their competitors from entering into the same industry. For example some companies have already built itself an extensive distribution channel that will become costly for newer products to accomplish what the company has already achieved.
• Human Capital – They may have not been important before but now more than ever, an employee’s knowledge and capabilities are also thought to add value to the company.

As you can see there are not only one but actually several factors that will affect a particular company’s earnings growth rate. The P/E ratio gives less of an accurate reflection of the potential to grow due to the calculation of past earnings which is trailing by twelve months. So if compared to the PEG ratio, it tells more about the status of the particular stock than the P/E ratio. The PEG ratio is the relationship between the earnings growth and the price/earnings ration and it is formulated as such; PEG Ration is the amount of the Price/Earnings Ration divided by the Annual EPS Growth. One thing you should take note of when using the Annual EPS Growth for calculation is that the number used can vary; the annual growth rate can be a forward/predicted growth or a trailing growth, or a one to five year time span. So it would be best to check with the source providing the PEG ratio to see what kind of number they use. Despite this, when you are looking at the PEG of certain companies, it is just the same as looking at the P/E ratio; which means that an undervalued stock is shown through the lower PEG.
Let’s put the PEG ratio to a test to get a better understanding of how it is used.

For example you are interested in purchasing a certain stock from one of two companies. And let’s say that the first company is into the beer business and the earnings of growth at 10% and also being relatively low is the P/E ration which is at 15. The other company which is a networking company has an annual growth of 20% in net income and the P/E ratio is at 50, which are all higher if compared to the first company. Tech companies are popular among many investors and they justify this based on the assumption that these companies have enormous growth potential. But is it really true? Let’s look back at our earlier example; the beer company has a PEG ratio of 1.5 after dividing the P/E ratio which is 15 with the annual earnings growth, at 10. And compare this to the networking company, by dividing the P/E ratio of 50 with 20 from the earnings growth rate and you will get a PEG ratio of 2.5. As you can see the tech company when compared to the beer company does not have the growth potential as justified by the high P/E ratio, and another thing to note is that the after the comparison was made it seems that the stock price is overvalued.

The P/E ratio is not as informative as the PEG ratio; however by subjecting the traditional P/E ratio to the impact of future earnings growth it will be able to produce the more informative PEG ratio. The PEG ratio provides better insight on the stock’s current valuation, and with the forward looking perspective that is provided, the PEG ratio will become a valuable tool for any investor who is trying to see whether the stocks that they are interested in have any real potential of growth in the future.