How much should I pay for a stock? Part 2

In Part 1 of "How much should I pay for a stock?" we learned how to evaluate a PE ratio to make apples-to-apples comparisons of "cost" between stocks.  However, if some fat-cat Wall Street fellow were to tell you that Restoration Hardware (RH), with a PE of 30, was cheaper than Visa (V), with a PE of 25, he wouldn't necessarily be lying to you.

What's the catch?  The Wall Street fellow is considering the growth of the two companies when evaluating the "cost" of their respective stocks.  In general, Wall Streeters care about three things when evaluating stocks/companies: growth, growth, GROWTH!!!  And let's be honest.  We as investors are no better.  We all want to grow our portfolios (I hope), and therefore, we are equally as interested in growth.  Let's consider some quick definitions so we can discuss this further.

Trailing PE: the current price of a stock divided by the summed earnings over the previous four quarters.  I'm not sure why this evaluation exists.  I've never used it.  If we could make money by looking at the past, there would be no need for time machines. 

Forward PE: the current price of a stock divided by the summation of the expected earnings over the next four quarters.  Now we're talking.  Where is my stock going, not where has it been.  We'll go into this more later, but just to ease you curious mind, analysts get paid to determine what a company is expected to make over the next four quarters. 

PE to Growth Ratio (PEG): the forward PE ratio divided by the expected EPS growth (in percent), typically annualized over the next 5 years.  This ratio allows us to consider the longer-term growth rate of companies in relation to their PE.

I know, I know.  How many ratios do those Wall Streeters need to justify their salaries?  In the example above, RH does in fact have a higher PE, which I neglected to tell you was the forward PE, than V.  However, RH is projected to grow EPS by 26% annually over the next 5 years, and V is projected to grow EPS by only 17% annually over the next 5 years.  Let's perform the PEG ratio calculations to analyze the claim our Wall Street friend made to us.

RH: 30(PE) / 26(% growth) = 1.15

V: 25(PE) / 17(% growth) = 1.47

There we have it.  Our Wall Street friend, in his never-ending quest (addiction, really) for growth, has informed us that RH's expected EPS growth rate justifies its higher PE and makes RH "cheaper" than V.

Common Cents Take:  As you can see, investing is simple math.  Anybody who can multiply and divide can get rich quick.  Why don't more people do this?  Oh!  I almost forgot what your original question was.  So, "How much should you pay for a stock?"  See you in Part 3, where I'll give you the tools to determine how much you should pay for a stock and, in doing so, debunk the notion that all you need to know is division and multiplication.