The valuation of a stock should consider more than just the stock price. It should take into account profitability and potential for growth and the broader market environment, including volatility and sector trends that may impact future performance. The P/E and PEG tools can help you to do that.
Incorporating Price-to-Earnings (P/E) ratios and P/E-to-Growth (PEG) ratios into your fundamental analysis is a great way to provide added context to your stock valuation techniques. They can be used to identify long-term valuation trends. This is what you need to know.
How do you calculate the value of a company?
The value of a company is determined by its market capitalisation or market cap. To calculate market cap, you multiply the total number of open shares by the share price.
Market Cap = Share Price x Number of Shares
Consider the example below.
| Company A | Company B | |
|---|---|---|
| Stock Price | $5 per share | $1,000 per share |
| Share Volume | 1,000,000 | 1,000 |
| Market Cap | $5,000,000 | $1,000,000 |
The price of the stock of Company B is higher than that of Company A, but Company A is 5 times more valuable than Company B. That said, analysing the price of a stock against other metrics can throw up additional insights into a company’s prospects and play a key part in determining its overall worth.
What is a P/E ratio?
P/E ratios put the price of a company in context with a company’s profit, or earnings. This calculation can be very helpful when determining the overall value of a stock. It is calculated by dividing the price of a share of stock by the profit it represents.
P/E Ratio = Share Price/ Earnings per Share (EPS)
Tip: The P/E ratio is sometimes referred to as a company’s multiple.
Let’s go back to the example above. If each company earns the same profit, how do you think that will impact the value of its stock?
| Company A | Company B | |
|---|---|---|
| Profit | $1,000,000 | $1,000,000 |
| Profit per Share | $1 | $1,000 |
| P/E Ratio | 5 | 1 |
Based on this analysis, Company B has a lower P/E ratio than Company A, which means investors are paying less for each dollar of earnings.
Tip: The lower the P/E ratio, the higher the value of the company.
What is a PEG ratio?
PEG ratios take future performance into consideration to offer a forward-looking view of a company’s value. The potential for future growth can greatly impact the current value of a company. For instance, a company that is part of an M&A bidding war could have an over-inflated share price with low sales growth.
To calculate the PEG ratio, divide the P/E ratio by the expected growth rate (or annual profit).
PEG = P/E ratio / expected growth rate
The example below highlights how two companies with the same P/E ratio but different year-over-year growth rates will have different PEG ratios.
| Company X | Company Y | |
|---|---|---|
| P/E Ratio | 20 | 20 |
| Annual Profit | 10% | 5% |
| PEG Ratio | 2.0 | 4.0 |
As you can see, Company X is growing twice as fast as Company Y. This indicates that Company X may have more potential value than Company Y.
When should I use P/E and PEG ratios?
Three ways to use P/E and PEG ratios include when comparing competitors, identifying potential growth and considering short-term and long-term performance.
- Comparing competitors: P/E and PEG ratios are useful when comparing companies in the same sector.
- Spot growth potential: A low PEG ratio might indicate undervalued growth.
- Balance short- and long-term: P/E ratios are a snapshot of today while PEG ratios help look to future performance.
Tip: P/E and PEG ratios are useful tools, but incorporate a range of other valuation metrics into your analysis.
Final thoughts
Understanding the difference between the price and value of a stock is critical when considering potential investments. This type of fundamental analysis is a proven method to help investors assess fair valuation.
While there are many factors that influence the value of a stock such as economic outlook, market trends, management effectiveness, and competitive position, calculating P/E ratios and PEG ratios can provide valuable insights into these critical decisions.
Visit the eToro Academy to learn more about using market data in stock valuation techniques.
Quiz
FAQs
- Why is market capitalisation more useful than stock price when valuing a company?
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Stock price alone does not tell you how much a company is worth. Market capitalisation accounts for both the stock price and the number of shares, providing a more accurate picture of a company’s total value.
- What is a “good” P/E ratio?
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A “good” P/E ratio depends on the industry, company size, and growth expectations. In general, a lower P/E ratio can suggest a stock is undervalued, but it may also reflect risk or slow growth. It’s helpful to compare P/E ratios to other industry peers and to use other analytical tools which can help to determine the prospects of a stock.
- When should I use the PEG ratio instead of just the P/E ratio?
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Use the PEG ratio when you’re considering a company’s future growth. The P/E ratio shows how much you’re paying for current earnings, but the PEG ratio adjusts for expected earnings growth, making it complementary to the P/E ratio and especially useful for evaluating growth stocks.
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