Perform this calculation to discover if a share is undervalued

Julie Brownlee, Fsp Invest, 30 Mar. 2015

Tags: peg ratio, what is the peg ratio, financial ratios, how to use the peg ratio, how to find undervalued shares, finding shares to invest in,

If you think you’ve uncovered an undervalued share, what sort of tests can you perform to check?

You could calculate a company’s PEG ratio.

So how can you do this?

Read on to find out…

How to calculate the PEG ratio

The PEG ratio compares a company’s price earnings (PE) ratio with its expected growth in earnings per share (EPS).

To calculate the PEG ratio, you do the following:

PEG ratio = PE ratio / expected annual earnings growth

If you get a PEG ratio of less than one, it can suggest a share is undervalued.

The pros of the PEG ratio over the PE ratio

Many investors use the PE ratio as a way to identify undervalued shares. But the PEG ratio has an advantage over the PE ratio as it takes growth into account.

The PEG ratio can also be useful for comparing shares of companies in the same sector.

Say you have two companies in the retail sector.

  • Company A has a PE ratio of 15 and it expects to grow its earnings 20%. This gives it a PEG ratio of 0.75 (15/20).
  • Company B also has a PE ratio of 15 and it expects to grow its earnings 5%. This gives it a PEG ratio of 3 (15/3).

Based on the PEG ratio, Company A looks the more attractive share to buy.

The disadvantage of using the PEG ratio

The problem with the PEG ratio is the expected growth of EPS you use. Past growth rates may be unrealistic. And analyst forecasts may not be very accurate either.

Due to this, it makes sense to be more cautious with the earnings growth rate than optimistic.

So there you have it, why you should perform this calculation to discover if a share is undervalued.

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