As a quick refresher, we've discussed PE and PEG ratios, and we sort of know how to compare two stocks in a 1-on-1, no-holds-barred cage match to the death, but we still don't have an answer to our question. We need some sort of benchmark to compare to the specific stock we're evaluating. Well, the fine folks at Standard and Poor's (S&P) created such a benchmark for us in 1923, the S&P 500 index.
The S&P 500 Index (I'll refer to it simply as "the Index") is a conglomeration of 500 large US companies intended to represent the "market average." The Index is used as the primary benchmark to measure one's portfolio performance and to compare the valuations of specific stocks against the average market valuation. The Index is quoted in a dollar amount, just as an individual stock is. Although you cannot directly invest in the Index, products have been created for individuals to invest in that mirror the Index. Additional popular indices include the Dow Jones Industrial Average, which traditionally tracks primarily industrial companies, and the Nasdaq Composite Index, which traditionally tracks primarily tech companies.
Just as with individual stocks, PE and PEG ratios can be calculated for the S&P 500 Index. Because the Index includes 500 companies intended to represent the market average, the PE ratio for the S&P index can be assumed to be representative of the market average. Let's run through a quick example comparing PEs of an individual stock and the Index, and then we'll consider how the PEG ratio affects our evaluation.
Let's use Restoration Hardware (RH) for our example. You can find earnings estimates, expected growth rates, etc. for free on many financial sites, although you'll notice that the values between sources frequently differ. Yahoo Finance is one I use pretty frequently. According to Yahoo, at the time of this writing, RH has a forward PE of 30. I prefer to use the Wall Street Journal's forward PE for the S&P index (see the link in the previous paragraph), which is at 17.5 at the moment. RH looks like it is a bit less than twice as expensive as the Index. Ouch! We're not done yet, though. We need to consider the respective growth rates of RH and the Index.
Yahoo lists RH's 5 year estimated growth rate at 26% and the Index's at 7.4%. Using this information, RH has a PEG of 1.15, and the Index has a PEG of 2.36. The PEG of RH is substantially lower than that of the S&P 500 Index. As such, RH is likely justified in its higher PE ratio and likely has room for further growth. So, RH at its current PE and PEG, would likely be a good long-term purchase.
Common Sense Take: The forward PE is a pretty straightforward relative comparison tool. The PEG ratio, however, requires some judgement for use. CNBC's Jim Cramer often states that the maximum PEG ratio at which he will still consider purchasing a stock is at 2.0. Personally, I consider the PEG ratio a bit goofy. Normalizing a forward (estimated) PE ratio with an annualized 5-year percentage growth estimate is just too many estimates for me to abide by any hard PEG ratio rules. Therefore, I use the PEG ratio as just another metric to apply common sense to, and I interpret the ratio differently on a case-by-case basis. Finally! We now know how much we should pay for a stock!
Let's use Restoration Hardware (RH) for our example. You can find earnings estimates, expected growth rates, etc. for free on many financial sites, although you'll notice that the values between sources frequently differ. Yahoo Finance is one I use pretty frequently. According to Yahoo, at the time of this writing, RH has a forward PE of 30. I prefer to use the Wall Street Journal's forward PE for the S&P index (see the link in the previous paragraph), which is at 17.5 at the moment. RH looks like it is a bit less than twice as expensive as the Index. Ouch! We're not done yet, though. We need to consider the respective growth rates of RH and the Index.
Yahoo lists RH's 5 year estimated growth rate at 26% and the Index's at 7.4%. Using this information, RH has a PEG of 1.15, and the Index has a PEG of 2.36. The PEG of RH is substantially lower than that of the S&P 500 Index. As such, RH is likely justified in its higher PE ratio and likely has room for further growth. So, RH at its current PE and PEG, would likely be a good long-term purchase.
Common Sense Take: The forward PE is a pretty straightforward relative comparison tool. The PEG ratio, however, requires some judgement for use. CNBC's Jim Cramer often states that the maximum PEG ratio at which he will still consider purchasing a stock is at 2.0. Personally, I consider the PEG ratio a bit goofy. Normalizing a forward (estimated) PE ratio with an annualized 5-year percentage growth estimate is just too many estimates for me to abide by any hard PEG ratio rules. Therefore, I use the PEG ratio as just another metric to apply common sense to, and I interpret the ratio differently on a case-by-case basis. Finally! We now know how much we should pay for a stock!
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