The price-to-earnings (PE) ratio is a commonly used valuation tool. A less commonly utilised tool is the PE to Growth (PEG) ratio, which reconciles the PE ratio with the earnings per share (EPS) growth of a company.
The benefit of using the PEG ratio is that it provides a comparison of the PE multiple you are paying with a specific rate of EPS growth.
Big share prices with big PE multiples rightly make some investors question whether a stock is expensive.
As the following three examples show, based on their respective PEGs, one of these stocks could actually be considered cheap!
REA Group Limited (ASX: REA)
The share price of Australia's leading online property classifieds operator has soared around 50% in the past year and is currently trading near $62.
Analyst consensus forecasts from Reuters for the 2016 and 2017 financial years are for 168 cents per share (cps) and 206 cps respectively. This implies an EPS growth rate of 22.6% and a PEG ratio of just 1.3 times.
Cochlear Limited (ASX: COH)
Shares in this world-leading implantable hearing solutions company have rallied almost 50% in the past 12 months to $124.
Consensus estimates show EPS rising from 333 cps to 382 cps over the next two reporting periods implying an EPS growth rate of 14.7% and a PEG ratio of 2.2 times.
Ramsay Health Care Limited (ASX: RHC)
Ramsay is a leading private hospital operator whose shares now sell at around $71 after gaining 15% in the past year.
Based on analyst forecasts for EPS to increase by 12% from 231 cps to 259 cps, the stock is trading on a PEG ratio of 2.3 times.
Foolish takeaway
On its own, a PE or a PEG ratio may not tell you a lot, however when compared against a peer group or the market as a whole, the relative valuation can prove insightful.
According to CommSec's data, the market's average PEG ratio is around 1.5 times and forecast average EPS growth is 10.4%.
Based on the above analysis, Ramsay and Cochlear do appear to be fully priced (or indeed expensive). Meanwhile, by digging deeper with the PEG ratio it would appear that there could still be upside in REA Group today.
