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Why I think the PEG ratio is very useful

There are many ways to compare shares. You can look at the price to sales ratio, the price to book, return on equity and various other metrics.

One of the simplest and perhaps better ways to compare shares is the price/earnings ratio. This calculates how ‘expensive’ a share is. It allows you to compare how expensive a $1 billion company is compared to a $100 billion company, despite the huge difference in size.

For example, if a company with a market capitalisation of $1 billion had $100 million in net profit after tax (NPAT) then it would have a price/earnings ratio of 10. A $100 billion company with $10 billion of NPAT would also have a p/e ratio of 10.

There are companies out there with p/e ratios in the 20s, 30s, 40s, 50s and higher. A p/e ratio of 20 sounds like it’s twice of expensive as my above examples. It is, but it doesn’t account for future earnings growth.

The more that a business is expected to grow next year and future years, the higher of a price it will trade at compared to today’s earnings.

The PEG ratio aims to account for this. It looks at the price/earnings ratio compared to the expected annual earnings per share (EPS) growth. If a share has a p/e of 20 and is expected to grow EPS by 20% then it has a PEG ratio of 1.

A PEG ratio of less than 1 will supposedly create better returns than shares with PEG ratios of above 1.

Foolish takeaway

Of course, you can’t just use the PEG ratio to decide on stocks, but I think it’s a helpful analysis. The PEG ratio would suggest that shares like Ramsay Health Care Limited (ASX: RHC) and Woolworths Group Ltd (ASX: WOW) are expensive despite their falls in recent years, whilst shares like Paragon Care Ltd (ASX: PGC) are cheap.

This top ASX share has a PEG ratio of under 1, yet this stock could be about to generate more growth as it expands overseas.

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Motley Fool contributor Tristan Harrison owns shares of Ramsay Health Care Limited. The Motley Fool Australia has recommended Ramsay Health Care Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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