PEG can prove invaluable for traders

In How to trade volatile markets, I showed how technical analysis can identify entry and exit points for a trade. This month we will explore fundamental analysis with the PEG (price/earnings ratio divided by growth).

But first a look at recent activity on the markets, and it's been an interesting three or four weeks, to say the least. At Interactive Investor we have seen a surge in activity as clients clearly agreed that 'Greece is the word'.

The market has seen some wild swings, falling from the 5900 level to below the psycholigically-important 5000-point mark, before moving back above 5300.

Debt concerns over the US, combined with fears Spain and Italy could go the way of Greece, hit markets heavily, while the Greek situation has provided traders with some opportunities to trade around short-term volatility, particularly in relation to some very attractive price/earnings (p/e) ratios for those prepared to take a longer-term view.

An eye on fundamentals

It is a common misconception that trading contracts for difference (CFDs) is just for day traders, but we find at Interactive Investor that many customers also use CFDs for long-term positions and not just for taking very short-term intra-day views across the markets.

Many traders will strike a balance between short-term trades - lasting from 10 minutes to a few days - with their longer-term plays. Others simply use CFDs to hedge their underlying portfolio, on a short-term basis, when situations such as the Greek crisis arise.

But some clients have also held CFD positions open for many months and even years, which requires taking in a more fundamental perspective.

So, for short-term views, technical analysis is key, but longer-term investors - whether trading CFDs or the underlying shares - looking more closely at fundamental analysis is a necessity and that's where PEG comes in.

Although the simple p/e ratio is a useful tool in stock picking as it refers to the price of a share relative to its earnings, it merely shows you how cheap, or expensive, a company's share price is. But being cheap it not necessarily a good reason to buy a share and recently you will have been spoiled for choice in this regard.

With the PEG ratio, however, we are looking for shares that are undervalued - or indeed overvalued if you are going short. PEG is simply the p/e ratio with the added factor of accounting for forecast growth.

But before we go on, let's be clear that there is no crystal ball to guarantee investment success - although there are plenty of charlatans out there who will beg to differ and take your cash for an insight into the holy grail of trading. There are also many other intervening market forces which will catch you out from time to time.

That said, PEG will help you to see how cheap a share is by measuring the relationship between the price, the earnings per share and the all important future growth. The calculation is: p/e ratio divided by forecast earnings growth.

Don't worry about having to reach for the calculator as there are lots of websites that readily supply you with this information.

The popularity of PEG is famously down to US fund manager Peter Lynch, who in his 1989 book One Up On Wall Street, stated: "The p/e ratio of any company that's fairly priced will equal its growth rate". Therefore the PEG of a fairly valued share should equal one.

In theory, a resulting PEG of lower than one is cheap and higher than one is expensive.

PEG allows you to evaluate shares more effectively. Your eyebrow may be raised when you spot a share with a p/e ratio of only five, but if its future growth rate is 5% it has a PEG of one - so it is fairly valued. Similarly, a company with a high p/e ratio may have an equally high growth rate.

When trading using PEG we can also track our entry and exit points. For example, you buy a stock with a PEG of 0.6 and as the price rises you notice the PEG rising to 1.5 and then to two. You might want to think about locking in your gains. Equally, if you want to trade short, look for shares that the PEG tells you may be overvalued.

Over the years I have used PEG it has worked much more often than not, but there are a few things you need to consider. Generally, it is safer to use a PEG on a one-year growth forecast as there is less room for the 'forecast' to go awry. You may prefer to trawl through historic data but the markets don't. If you find a stock with a PEG of 0, don't fill your boots. These companies are not making any money.

Mike McCudden is head of retail derivatives at Interactive Investor.