Trying to uncover undervalued shares? Here’s a financial ratio to help you

Julie Brownlee, Fsp Invest, 01 Sep. 2014

Tags: peg ratio, financial ratio, what is peg ratio, how to calculate peg ratio, how to find undervalued shares,

If you’re a value investor, you’ll spend much of your time trying to unearth undervalued shares on the stock market.

But what’s the best way to try to uncover shares that the market’s not yet realised the full potential of yet?

There is one financial ratio that can help you do just that. It’s the PEG ratio.

Read on to uncover what you need to know about the PEG ratio…

What is the PEG ratio?

The PEG ratio is a financial ratio that can help you find undervalued shares.

The PEG ratio works by comparing the price earnings (PE) ratio of a company to the expected growth of a company’s earnings per share (EPS).

To calculate the PEG ratio you divide a company’s PE ratio by its expected annual earnings growth.

What makes the PEG ratio useful is that it’s more reliable than using the PE ratio alone. That’s because the PEG ratio takes into account a company’s growth.

How to read the PEG ratio

If a company has a PEG ratio of less than one, it may mean a share is attractively valued. The ratio is most useful when you use it to compare shares of companies in the same sector or a similar industry.

Let’s take a look at an example…

Company ABC is in the telecoms sector. It has a PE ratio of 15. Analysts expect it to grow its earnings at a rate of 20%. This gives Company ABC a PEG ratio of 0.75 (15/20).

Company XYZ is also in the telecoms sector. It also has a PE of 15. But analysts only expect the company to grow its earnings at 5%. That gives Company XYZ a PEG ratio of 3 (15/5).

From looking at the PEG ratios of the two companies, Company ABC looks more attractive as its PEG ratio is less than 1.

The pitfalls of using the PEG ratio

When you calculate a company’s PEG ratio, you need to be careful about the expected growth rate of EPS you use.

If you use its past growth rate, it may be unrealistic that the company can repeat the same performance. Equally so, if you use analyst projections, you must also be careful. There’s no guarantee a company will match this and the forecasts may be wrong.

So there you have it, a financial ratio to help you uncover undervalued shares.

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