With two other bits of information, we can learn more from the P/E, specifically, the signature P/E and the earnings growth rate. The ratio of the P/E to the former signature P/E produces an historical value ratio (HVR) or relative value (RV). The ratio of the P/E to the latter projected earnings growth produces the “PEG” ratio — the P/E to growth rate.

The Importance of Relative Value

Let’s look at the relative value or RV. The RV is calculated by dividing the current P/E by the historical average P/E. Again, we must be sure to use a relevant historical average and not an average that includes either the “pumped-up,” inflated P/Es of recent years or distorted multiples derived from years when dismal earnings were reported after the high prices for the year were recorded.

A relative value of 100 percent would mean that the current P/E is the same as the historical average P/E, implying that the stock is selling for a “fair” price — a multiple that investors had considered to be fair and reasonable in the past. If the RV is much below 100 percent — say below 90 or 85 percent — that would be a good reason to be skeptical. “Why,” you should ask, “is this stock selling for a price that’s so far below what was previously considered a fair price?”

To consider such a stock a bargain and not explore the reasons for its falling out of favor would be foolhardy. It might be that the investing public knows something that you don’t know. But you should be able to find out the reason without too much difficulty — from the company’s Web site, from the financial news (perhaps from Yahoo’s site or another that conveniently provides a chronicle of news releases), or from the company’s investor relations department.

Of course, it might also be that there is no good reason for the low price and you can act the “rational contrarian” (as opposed to one that swims against the tide just to be contrary). Such a case occurred early in the Clinton administration when health care stocks took such a beating. The fact was that people got sick anyway, and all of the efforts to reduce the profits from those who served the sick accomplished nothing. So those companies the herd expected to suffer were still good investments—especially at those low prices.

But you’d better be sure. And if you’re not, you should look elsewhere for a place to put your money. If the RV is too high, say above 110 percent, it indicates that investors are paying above what has been considered a fair price. In those circumstances, it’s best to make sure that the return you expect from your investment is sufficient — and that the risk you must take to obtain it is reasonable. Otherwise, it may be best to wait until the price once again comes back down to earth before you take the plunge.

Up One Derivative: The PEG Ratio

The PEG ratio goes one step beyond the P/E as a means of measuring investor confidence. The faster a company’s earnings grow, the more confidence investors are going to express by paying a higher price. Hence the P/E will typically be higher for a high-growth company than for one whose growth is more sluggish. The PEG ratio is calculated by dividing the P/E by the forecast earnings growth rate.

Few use this as a predictive measure; but many like to limit their estimate of a reasonable multiple to one to one-and-a-half times the earnings growth rate. Thus, if earnings are expected to grow at a rate of 10 percent, they would consider a multiple of 15 to be as much as they would want to pay.
This, incidentally, is consistent with the limit that many NAIC investors observe for forecasting earnings growth. Many limit their growth estimates to 20 percent and their P/E to 30 times earnings for a P/E — which equates to a one-and-a-half PEG ratio. To summarize: The P/E is one of the most useful pieces of information for evaluating the price of a stock. Despite short-term price fluctuations, which can vary as much as 50 percent during the course of a year, the long-term value of a stock is based upon the company’s earning ability.

The P/E alone can be a rough but important gauge of value when considered in the context of the time it might take to recover your investment. Many are not willing to depend upon investors paying more than 30 times earnings for them to make money on the stocks they buy. When compared with the historical average multiple — the signature P/E — a low historical value ratio or relative value can be an alarm to caution you that the stock is selling at a price lower than that at which history has valued it. You ought to find out what, if anything, today’s investors know that you don’t that would cause it to fall out of favor. If too high, the relative value cautions you to wait until the price comes down to within reason.

The PEG ratio offers another reality check that ties together both components of a stock’s price: the growth of the underlying company’s earnings and the multiple of those earnings investors might be willing to pay. Using a reasonable PEG ratio to limit your forecast of either number can prevent you from being overly optimistic and relying upon either unsustainable performance or investor overconfidence to produce your gains.