Investing can sure seem confusing when you first get started. One reason is because there are so many different ratios out there to understand. But if you're simply trying to figure out if a stock is "cheap", I typically throw most of the other ratios to the side and use the PEG ratio.
The PEG ratio is the price-to-earnings-to-growth ratio. This ratio is a lot like the P/E ratio which divides the earnings from the price. But the PEG does more than just that; it also accounts for the growth rate. By taking the growth rate into consideration, it tells you if the company is overvalued or undervalued based on how fast it is growing.
If you've been investing for a little while now, you probably know what a P/E ratio is. The P/E ratio is not perfect because some companies are worth a high P/E and some aren't. For example, if ABD Corp had a PE ratio of 75, you might think it was overvalued. But if it was growing at 75% per year, it would be worth the price.
The PEG ratio is figured by taking the P/E ratio and dividing it by the earnings growth rate. For example, if XYZ corporation has a P/E ratio of 26 (about average) and a growth rate of 15% per year, its PEG ratio would be 1.73 (26/15). For all of you mathematicians out there, here is the equation to calculate the PEG:
Price / Annual earnings / Earnings Growth Rate
Once you've done the math and figured the PEG ratio, you now have to interpret it. Here's a small table of what the different numbers mean:
The PEG ratio isn't perfect. Even if a stock has a very low PEG, it doesn't mean that the stock will definitely go up. However, it is generally more likely that a stock with a low PEG is a good investment. I recommend using the PEG to compare a few different companies in the same sector...it usually helps you pick the most undervalued one.