Hot Money Monday: There’s a flaw in P/E ratio, so you may find cheap stocks better this way

The P/E ratio can be misleading as it doesn’t account for growth potential. Here’s a more refined way to find undervalued stocks.

The PEG ratio, created by Benjamin Graham, incorporates growth rates. Picture Getty

• The P/E ratio can be misleading as it doesn’t account for growth potential

• The PEG ratio, created by Benjamin Graham, incorporates growth rates

• We look at ASX stocks with some of the best PEG ratios 

The Price/Earnings (P/E) ratio is a popular tool among investors, but it can sometimes steer them in the wrong direction.

Imagine you’re comparing two stocks in the same industry: Stock A with a P/E ratio of 10, and Stock B with a P/E ratio of 15.

At first glance, Stock A might seem like a better deal because it's priced lower relative to its earnings compared to Stock B.

But the P/E ratio overlooks important elements that determine a stock’s value.

For example, the difference in P/E ratios between Stock A and Stock B doesn’t reveal anything about their growth rates.

If Stock B is growing at an impressive 20% per year, while Stock A is growing at a slower 10% rate, many investors would prefer to invest in Stock B despite its higher P/E ratio, because of the potential for future growth.

The point here is that you can’t rely on a single metric like the P/E ratio in isolation. It’s crucial to consider both growth rates and other associated risks.

Introducing the Price/Earnings-to-Growth Ratio

To gain a fuller picture, value investors often look at the Price/Earnings-to-Growth (PEG) Ratio, which incorporates growth into the equation.

Benjamin Graham, known as the "father" of value investing and Warren Buffett's mentor, created the PEG ratio to find stocks that are not only undervalued but also have strong growth potential.

PEG Ratio = Share Price / EPS
EPS Growth

where EPS = Earnings per share

A lower PEG ratio generally indicates a more undervalued stock.

Let’s say Stock A has a P/E of 10 and its annual earnings are expected to grow by 10% over the next five years.

By dividing the P/E ratio by the growth rate, we get a PEG ratio of 1.

In contrast, Stock B with a P/E of 15 and an annual earnings growth rate of 20% results in a PEG ratio of 0.75.

This lower PEG suggests that Stock B is actually a better value despite its higher P/E ratio.

“Generally, a PEG ratio below 1 indicates that the share price is trading at a discount to its expected earnings growth, suggesting that the stock may be undervalued by the market,” said a note from The Street’s Bernard Zambonin.

Be careful of these when using PEG ratio

The reliability of the PEG ratio, or any ratio for that matter, obviously hinges on the accuracy of its inputs.

When you encounter a PEG ratio from a published source, it’s crucial to know which growth rate was used in the calculation.

If historical growth rates were used instead of expected future rates, the PEG ratio could be misleading, especially if the company's growth trajectory is anticipated to change.

While future growth rates incorporate the latest market conditions and economic factors, historical growth rates might not account for recent changes that could significantly impact a company's future earnings.

Another important consideration when using the PEG ratio is to compare companies with their peers from the same sector.

This is because different sectors have unique growth dynamics.

Comparing a tech company to a utility company using the PEG ratio, for instance, wouldn’t be meaningful, as tech companies generally have higher growth rates.

ASX companies with best PEG ratios

Zambonin notes that a particular US stock, Nvidia, has a PEG ratio of less than 0.2 today.

“A PEG ratio this low suggests that the company's earnings growth potential is high relative to its current price. This presents an opportunity for investors to potentially earn solid returns on their investment.”

This is not a comprehensive list, but we've trawled the ASX for some of the small and large caps with the lowest PEG ratios.

All data from Commsec.

ASX Small Caps with the best PEG ratios

Code	Name	PEG Ratio
MMI	Metro Mining	0.05
GTN	GTN	0.05
SDV	SciDev	0.07
HUM	Humm Group	0.14
ERD	EROAD	0.18
CLG	Close the Loop	0.24
TYR	Tyro Payments	0.25
ATM	Aneka Tambang	0.27
OBM	Ora Banda Mining	0.28
KGN	Kogan.com	0.31
MAH	Macmahon Holdings	0.33
PLY	PlaySide Studios	0.38
OML	Oohmedia	0.41
FLN	Freelancer	0.47
AFP	AFT Pharmaceuticals	0.5
SPZ	Smart Parking	0.65
GTK	Gentrack Group	0.83
OFX	OFX Group	0.87

ASX Large Caps with the best PEG ratios

Code	Name	PEG Ratio
DXS	Dexus	0.06
AGL	AGL Energy	0.12
EVN	Evolution Mining	0.17
GPT	GPT Group	0.22
AIA	Auckland International Airport	0.29
FLT	Flight Centre Travel Group	0.37
MEZ	Meridian Energy	0.39
CHC	Charter Hall Group	0.43
WDS	Woodside Energy Group	0.46
MGR	Mirvac Group	0.58
MCY	Mercury NZ	0.63
NST	Northern Star Resources	0.65
ALD	Ampol	0.66
RHC	Ramsay Health Care	0.7
CPU	Computershare	0.72
MQG	Macquarie Group	0.78
GQG	GQG Partners Inc.	0.82
IAG	Insurance Australia Group	0.9

Now read: Price Earnings Ratio: How you should (or shouldn’t) use it to find undervalued stocks

Originally published as Hot Money Monday: There’s a flaw in P/E ratio, so you may find cheap stocks better this way