Value investors look for cheap stocks. Although that’s a good idea, it can be tough to define “cheap.”
Popular tools such as the price-to-earnings (P/E) ratio can define value. Simply put, stocks with low P/E ratios are defined as having better value than stocks with high P/E ratios.
Now, the problem with low P/E ratio stocks is that some actually deserve a low P/E ratio. A company should be cheap, for example, if it’s headed for bankruptcy.
Despite such shortcomings, the P/E ratio is still useful. And with a small modification, it’s a powerful indicator that reveals which types of stocks are a steal for buyers.
The Power of the PEG Ratio
Value investors often ignore the fact that different stocks should have different P/E ratios.
They may say a stock is cheap when the P/E ratio is under 10. But if the company is failing, it deserves a single-digit P/E ratio.
On the other hand, a company that is growing rapidly deserves a high P/E ratio. Growth companies could be bargains with a ratio as high as 30.
The price/earnings-to-growth (PEG) ratio is beneficial because it adapts the P/E ratio to the company’s prospects. It divides the P/E ratio by the company’s earnings growth rate.
So, a low PEG ratio highlights undervalued opportunities, no matter what the P/E ratio is. And a high PEG ratio warns of overvaluation.
PEG ratios can also be applied to indexes. The chart below shows the PEG ratio of the large-cap S&P 500 Index as the green line. The red line shows the PEG ratio of the small-cap Russell 2000 Index.
PEG Ratios for Russell 2000 and S&P 500
(Source: Standard & Poor’s.)
In the chart, the PEG ratio for the S&P 500 is 1.89. For the Russell 2000, it’s 1.15. As is true for any value indicator, low values usually show which stocks offer the most upside potential.
Right now, the Russell 2000 offers more value than the S&P 500. This makes a bullish case for small-cap stocks.
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Michael Carr, CMT, CFTe
Editor, One Trade