Which Is the Better Valuation Metric? The P/E Ratio or the PEG Ratio: Part 1
Recently, I have been engaged in rather intense discussions regarding the validity of P/E ratios versus PEG ratios as proper or appropriate valuation metrics. I generally find these types of debates befuddling for a couple of reasons. One, they are often a result of a failure to communicate. Either party or sometimes both parties assume that their adversary holds or supports a specific position which may or may not be a fact.
From my perspective, this was precisely the case regarding the discussion cited in my opening sentence. Assumptions were made regarding my positions on P/E ratios and the PEG ratio that were not positions that I actually hold. Consequently, it is hard to argue or debate an issue when you are essentially being required to defend a position that you do not hold.
The second reason I find these types of discussions puzzling is because they are often over generalized. Financial metrics such as the P/E ratio or the PEG ratio, like most financial metrics, have their place and their value in financial analysis. Consider that a P/E ratio is a statistical metric referencing a single point in time.
However, in the real world, the P/E ratio is a dynamic measurement that is constantly changing over time. Moreover, just as it is with all financial metrics, I don’t believe any metric is supremely valuable in a vacuum. In my experience and opinion, all financial metrics will only bring investors value and insight when utilized relative to other metrics.
Therefore, with this series of articles I will share my perspectives, opinions and insights into how both the P/E ratio and the PEG ratio can be appropriately utilized by investors towards making better informed investment decisions on common stocks. Additionally, I will discuss how both of these commonly used financial metrics are for all intents and purposes joined at the hip. In other words, they are more interrelated metrics than they are separate or distinct valuation tools.
The P/E Ratio: Definitions and Insights
The P/E ratio is one of the most commonly utilized tools for the serious common stock investor. It is, however, one of the most misunderstood and misused tools. Learning how to use it properly and understanding its significance can significantly increase returns and lower risk.
The P/E Ratio - Definitions:
The P/E Ratio can be defined in several ways, with each definition adding insight to its significance. The simplest definition is simply the price of the common stock divided by its earnings per share. This is a basic mathematical definition expressed as follows: PRICE/Earnings = P/E Ratio.
A second commonly used definition is: The P/E Ratio is the price you pay to buy $1.00 worth of a company's earnings or profits. For example, if a company's stock has a P/E Ratio of 10, then you must pay $10 for every dollar's worth of that company's earnings or profits you buy. If its P/E Ratio is 20, then you pay $20 for every dollar's worth of that company's earnings or profits, and so on.
It is important to note, however, that a higher P/E Ratio does not necessarily mean that the company has a higher valuation or that it is more expensive than a company with a lower P/E Ratio. This fact is not understood by many investors and is the key reason that the P/E Ratio has little value by itself or if used in a vacuum. It is theoretically possible, depending on each company's future prospects, that a company with a P/E Ratio of 10, for example, can be significantly more expensive than a company with a P/E Ratio of 40. I will elaborate on this important point later.
A third definition would be: How many years in advance you are paying for this year's earnings. For example, if a company has a P/E Ratio of 20, then you are paying 20 times this year's earnings. If the P/E Ratio is 10, you are paying 10 times this year's earnings, and so on. This definition illustrates a simple premise of what an operating business is worth.