Readers will know that when assessing the forward rating of a stock, it’s important to factor growth rates – whether they be projected or historical – into the equation. The price/earnings (PE) ratio – the effective default option in terms of ratings – is a useful starting point as it provides insight into whether a stock is overvalued or undervalued with reference to its specific industry group, its historical multiples or perhaps an index benchmark.
However, no measure should be used in isolation, and the most significant drawback of the PE ratio is that it reveals little about earnings growth prospects. To address this limitation, investors often employ the PEG ratio as it reflects the relationship between the PE ratio and projected earnings growth.
It’s generally held that the measure is more illuminating when it’s applied to smaller companies, although you could make the argument that valuations at this end of the spectrum have become more illusory since the advent of quantitative easing (QE). It is more difficult to make definitive judgements when excess liquidity is a feature of the market. Yet anyone who follows the musings of Simon Thompson will recognise that small-caps are more likely to be undervalued than blue-chips. And this realisation alone explains why it’s important to gauge how expensive a stock is relative to its growth rate.