U.S. stocks rebounded Wednesday, recovering a significant portion of their losses from the day earlier. As a general rule of thumb, the average P/E ratio for the entire stock market over many decades going back to the 19th Century is 15. Stock market analysts and participants generally consider a stock market with an average P/E ratio below 15 to be undervalued and a stock market with an average P/E ratio above 15 to be overvalued. However, due to the many factors that affect corporate earnings, such as economic growth and interest rates, the average stock market PE ratio can sometimes reach levels that are far below or above the long term average of 15.
A major criticism of the P/E ratio stock valuation method is that it is backward looking, since it is based upon the past year of company earnings per share. The PEG ratio is a useful stock valuation method because it provides guidance regarding a stock’s value in relation to its earnings growth rate, which is the primary factor that drives stock prices higher. To calculate a stock’s PEG ratio, divide the stock’s current P/E ratio by stock analyst’s consensus regarding the forward earnings growth rate for the year ahead.
A PEG ratio above 1 indicates a stock that is overvalued relative to the future earnings growth rate, while a PEG ratio below 1 indicates a stock that is undervalued relative to the future earnings growth rate. Declining earnings will lead to a rising P/E ratio, which will hinder the stock from rising in price in the future due to declining valuation.
However, if ABC Inc’s stock has a P/E ratio of 20, and is growing earnings at only 30% per year, then the PEG ratio is 0.66, which indicates the stock is undervalued relative to future earnings growth, and its prospects of moving higher based on growing earnings over the next year are favorable. Earnings Yield – The Earnings Yield valuation is calculated by taking the earnings per share for the past year (or twelve month period) and dividing the earnings per share by the current market price per share.
It is important to keep in mind that future earnings growth is the most important metric when valuing how inexpensive a stock is and what the prospects are for a stock to move higher in price. The cheapest stocks in the stock market are actually the ones that have good projections for futures earnings growth, and are not the necessarily the stocks that trade for the lowest prices and appear cheap. The following article explains what you can expect when a market begins a corrective phase.