hi i'm jimmy in this video we're going to walk through the peg ratio
peg is short for price to earnings growth
the goal of this video is to help us better understand the peg ratio
and hopefully be able to use this to help us
make better investment decisions and ideally get us closer to our goal of
achieving financial freedom okay so what is the peg ratio well the
peg ratio is a way to account for the growth of a
company's earnings when it comes to valuing a stock so many
of us have heard of the very popular price to earnings
ratio to illustrate what the price to earnings ratio is
we're simply going to take the price per share of the stock
and then we're going to divide that by the company's earnings per share
so we have two examples that we're looking at we're looking at intel
and amd i'm using these because i recently did a video
where i analyzed intel stock so it's fresh in my mind
okay so intel over the past 12 months has an adjusted earnings per share
of 5.17 amd on the other hand over the same time period has adjusted
earnings per share of 69 cents per share okay simple enough and as of the
shooting of this video intel is trading at about 48.50
per share well amd is at about 77.67 so if we were to do this quick math well
we can see that the p e ratio for intel is about 9.3 x
and for amd it's about 112x so what does this mean well to simplify
it it means that for every unit of earnings that the company
generates for every dollar of earnings that the company generates
for intel would be willing to pay nine dollars
for one dollar of earnings we pay nine and the company earns
one dollar for every nine dollars that we pay and if we bought amd
well we would be paying a hundred and twelve dollars for a dollar in earnings
now if we knew nothing else about this information
we might look at this and say well that's crazy
i would never pay 112 times earnings when there's another company that's
similar to that but we can only pay 9.3 times earnings
but now what if i told you that between now and 2024
the expected growth of intel for their earnings per share
is it's expected that intel will grow by about 3.6
percent per year meanwhile amd is expected to grow
at about 36 percent per year well this is a completely different story we
should be willing to pay more for amd since amd is bringing in this case a lot
more growth to the table okay so now we know that the
price to earnings ratio is how much we're paying
per unit of earnings what the peg ratio does
peg don't forget to short for price to earnings growth
well what it does is is it tells us how much we're paying
per unit of expected growth essentially the peg ratio standardizes
the p ratio and adjusts them so you can
compare different companies with different growth rates so
it standardizes the pe ratio and makes it a bit more usable all we do
now is we take the p e ratio and we divide that by the expected growth rate
so for intel we take the 9.3 that's the p e ratio we divide that by the 3.6
expected growth of earnings and we end up with a peg ratio
of about 2.6 okay simple enough now with amd we take the 112 divided by
the 36.2 expected growth rate and we get a peg
ratio of 3.1 now we should recognize that the lower
the number the the lower the peg ratio is
the better so for the case of intel well here we can see that we are paying we
are paying a p e of 2.6 times
each unit of growth so are we willing to pay 2.6
times each unit of growth and for amd we're paying
a pe of 3.1 per each unit of growth and this is one of the advantages of the
peg ratio initially the numbers looked to be
insane if we were only looking at the p e ratio
well in that case we go with intel hands down but thanks to the peg ratio
well now we can see that relative to intel amd
may not be quite as overpriced as we originally thought
since they have much better growth but the flip side of that or the weakness of
the peg ratio is that the peg ratio doesn't account
for risk neither does the p e ratio but when we
added growth clearly that doesn't account for
uh for risk anywhere in that so now we might look at this and say
okay what if we think intel is more risky
they are coming off of some bad news uh they recently delayed
some major products that they've been working on due to operational issues
which is never a good thing meanwhile amd is pumping out better and better
products so perhaps the 0.5 spread between
amd's and intel's peg ratio is perfectly justified
or perhaps we look at this and we say intel is a safer company
after all if we added up the revenue that amd
has generated not the profit the revenue that they've generated
going all the way back to the fourth quarter of 2015 all the way up to today
well intel has more cash than that on hand right now
cash and cash equivalents so that's a big difference intel's second quarter
alone generated more revenue than amd has over the past two years
so perhaps intel is a safer company now clearly the market has an answer to this
question right now they're saying who's riskier well intel
is riskier that's why it's trading at a discount or
perhaps it's undervalued or amd is overvalued maybe both
the question is do we agree with the market or do we have
a different opinion and that's at the end of the day really an opinion thing
so there's one other thing that we should consider with the peg ratio
technically when the peg ratio was created it was designed
to compare numbers to the number one so if the ratio came in at higher than
one then it was overvalued if it came in at
one it was fairly valued and if it came in at less
than one then it was said to be undervalued and in theory if we invested
in the undervalued companies companies with a peg ratio of less than
one it would return better for us in theory now i was curious how often a
company might actually fall below one
so take this for what it's worth worth since it's just
intel i pulled down intel's historical numbers going back to 2015.
and from the data that i could find it looks like
they never fell below one now this ratio was originally created in the 1960s and
i'm not 100 sure that the implication there is that the
multiples would always stay the same throughout history
and i'm not sure that's a fair assessment to make but either way
this doesn't necessarily mean that there's no use for the peg ratio
i think that it makes sense to simply add the peg ratio
to something that we watch and as we illustrate it with amd and intel
it can help provide another piece of information and it's another thing for
us to consider when making investment decisions i also
think it can make sense to combine the peg ratio with another
viable valuation method if you're curious to see some more
choices for how we can value different types of stocks or different types of
industries well i actually did a video on that
exact topic where i run through some of the popular valuation methods
if you're curious perhaps that could be a good next video
for you to watch i've got a link right here i've got a link in the description
below and thank you so much for sticking with
me all the way to the end of the video i really appreciate it thanks and i'll
see in the next video