How to Choose the right Stocks (one of the steps)

Take guru Peter Lynch's investment mantra to heart -- one must first find the companies whose long-term prospects look good and have good management quality and then check whether their share price is under-valued using the PEG ratio.

PE ratio, that is the Price/Earnings ratio is a common valuation number used by investors in stocks. The PE number gives an idea as to whether the stock is under-valued or over-valued.

It is defined as: PE ratio = market price of the share / earnings per share.

Mathematically, the lower a PE stock appears, it's considered better than a higher PE stock. But is it really so?

Why do we buy a stock? We buy it so that when its price goes up, we can sell it and make profit. But why should the price of the share go up? Again simple, the price would go up if the company makes higher profits i.e. higher earnings per share (There are, of course, many other reasons for share prices to go up, but from the fundamental perspective, the price of a share is ultimately a reflection of it's profits).

Comparing the two i.e. the PE ratio and the EPS growth of a company gives a more meaningful picture. PEG ratio or the Price Earning Growth Ratio is defined as: PEG ratio = PE ratio / EPS growth rate

PEG ratio=1 This means that the share price is fully reflecting the company's future growth potential i.e. the share at today's prices is fairly valued.

PEG ratio>1 This indicates that the share price is higher than the expected growth in the company's profits i.e. the share is possibly over-valued.

PEG ratio<1 This indicates that the share price is lower than the expected growth in the company's profits i.e. the share is possibly under-valued.

Therefore, the PEG ratio tells us something more about the future potential of the company. It tells us whether the high PE is a superficial number or is supported by future growth prospects.