How the PEG Ratio Works

The PEG ratio is an indicator for determining the potential value of a stock while taking into account its price relative to its earnings growth.

PEG = Price / EPS (earnings per share) / Growth Rate

ex. $19.91 / $0.70 / 15.0% = 1.89 PEG for EMC

The lower the PEG, the more undervalued a stock is. The higher the PEG, the more overvalued the stock. Convention says a security with a PEG < 1.0 is cheap while a PEG > 2.0 is expensive. The value of 1.0 is believed to be fair value, but it can be adjusted when comparing a stock to its industry. A low PEG expresses the lack of demand for a stock which can be explained for several reasons. A stock with a high PEG is generally beating market expectations to deserve a price premium. Be aware that these numbers do not project all aspects of a security like cash flow, balance sheet, etc.

PEG for Industry / PEG for Stock x Current Price of Stock = Theoretical Price of Stock Compared to Industry

ex1. $33.35 / $5.04 / 16.9% = 0.39 PEG for WCG
Industry PEG = 1.37
Sector PEG = 1.62
Market PEG = 1.44

1.37 / 0.39 x $33.35 = $117.15 for WCG

Wellcare Health Plans Inc. appears to incredibly cheap since it is trading at a huge discount to its industry, sector, and the market. This security should be worth about 3.51 times its current value if it were to equal its industry. However if you put it under the microscope, you will find out that the price has plummeted due to an FBI raid on 10/25/2007. The allegations of fraud, lack of transparency, and sentiments of fear has marked down the share price and for good reason. An investor of this security would have to consider the risk/reward. If convicted of fraud, then the stock could go to $0. If Wellcare is innocent of any wrongdoing, then the share price should go back to previous levels in time. Always do your homework and perform background checks on your investments.

ex2. $206.85 / $1.35 / 50% = 3.06 PEG for FSLR
Industry PEG = 1.49
Sector PEG = 1.49
Market PEG = 1.44

1.49 / 3.06 x $206.85 = $100.72 for FSLR

First Solar Inc. looks to be extremely expensive when paying about double for its growth. Perhaps the analysts have it wrong when predicting a 50% growth rate as the market may be suggesting a 100% growth rate. In any case, the stock is overpriced on a valuation basis and appears to be inflated by speculators. On a technical level, FSLR has become parabolic and is due for a correction to find support. Unless earnings catch up, the share price should go sideways or fall to meet up with "fair value."

In my opinion, both WCG and FSLR are bad investments. Although Wellcare Health Plans is uber cheap, the allegations of fraud from the FBI are overwhelming and it is not worth the risk to buy. On the other hand, First Solar is too expensive at current prices and would not be worth purchasing until it pulls back. However, its high growth rate and strong performance makes it a much better investment over WCG since the downside is more limited while the upside can be incredible.