Your Money Question: A growth measure for bargain stocks

November 7, 2007

A friend says I should invest in a certain stock because it has a low price-earnings ratio, but does that automatically mean the stock has growth potential?

Q. A friend says I should invest in a certain stock because it has a low price-earnings ratio, but does that automatically mean the stock has growth potential?

A. No. A low price-earnings ratio tells you that the stock's current price is appealing relative to the company's earnings, but it doesn't consider future growth potential. One way to factor that in is to look at the PEG ratio-the price-earnings ratio divided by the earnings-per-share growth rate projected for the company over, say, the next 12 months. According to the broad rule of thumb, a PEG of around 1.0 means the stock is probably priced fairly. If the PEG is less than 1.0 the stock may be undervalued given the growth expectations. A PEG greater than 1.0, as you'd expect, means the stock may be overvalued. You can find a stock's PEG ratio for the current fiscal year at www.morningstar.com. (Enter the stock's ticker symbol, click on Valuation Ratios, then on the Forward Valuation tab.)

But like all stock measures, PEG has its weak points. It's most useful in evaluating small- or mid-sized growth companies that pay minimal or no dividends. For large established firms that pay hefty dividends, those that are losing money or that have cyclical growth patterns, and those whose assets greatly affect worth (such as financial institutions), PEG can be misleading. So use this as another tool in your evaluation arsenal but not as the sole guide for buying or selling a security.

For other measures worth considering when evaluating a stock, see "Your Money: Pick stocks like a pro," in the March 16, 2007, issue of Medical Economics.