The Right Questions To Ask About Stocks: Is it Growing?

The third part in our series on The Right Questions to Ask About Stocks takes a look at a company's growth. We've learned about the earnings of a company and how to relate it to the price of the stock via the price to earnings ratio. Once we've compared the stock's price to its earnings, the next thing we want to know is whether those earnings will increase or lessen.

Which Growth Are We Talking About?

We're looking at growth in the company's earnings over time, but there are several ways to look at this growth. The most obvious distinction is between historical and estimated earnings.

A company's historical earnings represent the money they've made in recent history. You can look at the company's growth over any period of time. For example I might see that McDonald's (MCD) has had an annual growth rate of 18.47% over the last five years. That can help us draw some conclusions about the strength of McDonald's, but what would be really informative would be to know how much it's going to grow in the next five years.

Estimated Earnings and the PEG Ratio

Sadly we can't know for sure how quickly a company will grow in the future, but there are people who are paid to make an educated guess at just that number. These guys are analysts, and part of their job is to predict how quickly a company will grow. Different analysts will predict different numbers, but the average of these numbers can be used to get a rough idea of how quickly the company might grow.

Back to McDonald's: the analysts, on average, think that McDonald's will grow at a 10.18% pace. We can use that estimate, along with the P/E ratio, to decide if a company is a good value. If we take the price to earnings (P/E) ratio and divide it by the estimated growth rate, we get what's referred to as the PEG (which stands for Price-Earnings-Growth) ratio. In the case of McDonald's, the 16.84 P/E divided by the 10.18% growth gives us a PEG ratio of 1.65.

Is That A Good PEG?

Here's a rule of thumb about PEG ratios: lower is better. Because price is being divided by growth, a large "growth" number and a small "price" is going to give you a smaller number.

PEG ratios are useful as a comparative tool across companies of similar sizes similar industries. For example, if I'm comparing McDonald's and Taco Bell owner Yum! Brands (YUM), I can see that YUM has a PEG ratio of 1.58 compared to McDonald's 1.65, which means you're getting more growth and earnings from YUM for the same amount of money.

Where Can I Find These Numbers?

There are many places to find financial numbers on the Internet, however I've found Yahoo finance to be a good compromise of ease of use and quality. When looking for growth numbers, take a look at the "Analyst Estimates" tab:

The section you're interested in is at the bottom on the left:

Usually the numbers we'll be most interested in are:
--The growth over the last five years, and
--The predicted growth for the next 5 years.

You can see they also give you the PEG ratio and P/E ratio. So this is a one stop shop for several numbers that we need to determine whether a stock might be a good value.

Of course, just like the P/E ratio, this one number doesn't tell you the whole story. The PEG ratio does, however, help you see an additional factor. Each new number we add is an additional dimension of analysis that helps us make better decisions.

This post appears in the Festival of Stocks. Be sure to head over there and check out more great articles.<.em>