How to Evaluate if a Company is Fairly Valued Using the PE Ratio?

Table of Contents

1. A stock is considered fairly valued from a PE perspective when:

   1. The Current PE ratio is below the average of the past 5 years range

   2. The Company's Net Income has been increasing

      1. Bonus: when (Past 12 months EPS growth rate + Dividend yield) > current PE ratio

      2. Bonus: PEG is < 1

         1. Not a deal breaker however when PEG > 2

   3. The Profit Margin has been increasing

2. How to Find the PE Ratio Trend?

3. How to Find the PEG Ratio Trend?

4. Examples of Companies That Fit the Framework

5. Examples of Companies That Don’t Fit the Framework

6. Notes on Limitations of this Method
   

Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.

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When analyzing whether a company is fairly valued from a PE ratio perspective, it’s important to assess more than just the absolute value of the ratio. The following framework provides a systematic approach to determine if the company is trading at a reasonable valuation:

A Stock is Considered Fairly Valued from a PE perspective when:

1. The Current PE Ratio is Below the Average or at the Low End of the Past 5 Years PE Range

   • This indicates that the stock might be undervalued compared to its historical valuation trends.
     

2. The Company’s Net Income has been Increasing in the past

   • Rising net income ensures that the company is not just cheaper because of declining profitability but is instead delivering consistent growth in earnings.

   
   

   1. Bonus: when (Past 12 months EPS growth rate + Dividend yield) > current PE ratio

      • Not favourable when the current P/E ratio is higher than past Net Income growth rate + Dividend Yield multiply by 2 [1]
        

   2. Bonus: PEG is < 1

      • Not a deal breaker however when PEG > 2

   
   

since PEG is calculated with PE divided by Expected EPS growth,

1. Expected EPS growth requires analysts' forecasts and they are often subjected to mistakes since projecting future earnings is no easy business.

2. Furthermore there have been a few cases where there are many stocks which prices continue to rise even when its PEG was > 2, for example:

   1. Fortinet's PEG was mostly above the 2 line in the past 5 years

      

      and yet its stock price rose 482% in the same period

      

      
      

   2. Axon's PEG was consistently above 2 in the past 5 years

      

      and yet its stock price rose almost 8x in the same period.

      

      
      

   3. Other notable examples include Microsoft, Apple & SPS Commerce.
      

3. The Profit Margin has been Increasing in the past

   • An expanding profit margin suggests improved operational efficiency, pricing power, or reduced costs, further supporting sustainable earnings growth.
     

   
   

How to Find the PE Ratio Trend?

• Visit financecharts.com > Valuation Charts > Select PE Ratio > Adjust to a 5-year (or 3-year) period.

  • For companies that have only recently turned profitable, the 3-year period may provide more meaningful insights.

How to Find the PEG Ratio Trend?

• visit Stockanalysis.com > Financials > Ratios, adjust period to Quarterly basis.

  

  
  
  
  

Examples of Companies That Fit the Framework

1. Fortinet (FTNT) – PE Ratio: 46x

1. ✅ PE Ratio: Current PE is below the average line of the past 5 years.

   

2. ✅ Net Income: Increasing consistently.

   • ✅ Past 12 months EPS Growth rate (52%) higher than current P/E ratio (46x)

     

     
     

3. ❌ PEG > 1

   

4. ✅ Profit Margin: Improving steadily.

   

2. Netflix (NFLX) – PE Ratio: 48x

• ✅ PE Ratio: Current PE is below the average line of the past 5 years.

  

• ✅ Net Income: Rising steadily.

• ✅ Past Net Income Growth rate (61%) higher than current P/E ratio (48x)

  

• 😐 PEG = 1.53

  

  
  

• ✅ Profit Margin: Increasing over time.

  

• 📌 Additional Note: Netflix’s management has outlined clear strategies to enhance profitability, such as increasing subscription prices, which could positively impact their bottom line.
  

3. MercadoLibre (MELI) – PE Ratio: 64x

• ✅ PE Ratio: Current PE is below the average of the past 3 years (5 years not usable).

  

• ✅ Net Income: Growing steadily.

  

• however past year Net Income Growth of 46% is not higher than current PE ratio of 65x.
  

  

• 😐 PEG = 1.59

• ✅ Profit Margin: Gradually improving.

  

Examples of Companies That Don’t Fit the Framework

1. Apple (AAPL) – PE Ratio: 37x

• ❌ PE Ratio: Current PE is above the average line of the past 5 years.

  

• ❌ Net Income: Flat or declining.

  

• ❌ PEG > 2

  

  
  

• ❌ Profit Margin: Moving sideways, showing no improvement.

  

Notes on Limitations of this Method

This method is not as applicable to companies that are:

1. Not Yet Profitable: Without earnings, the PE ratio isn’t meaningful.

2. Just Turned Profitable: In such cases, it’s better to use the PS (Price-to-Sales) Ratio for valuation analysis.

   • 📖 For more insights, read: Avoid Investing in Stocks with PS Ratios Above 18x When Stock is at All-Time High Level.

Final Thoughts

By combining the PE ratio trend with growth in net income and profit margins, you can form a more holistic view of whether a stock is trading at a fair valuation. This method is especially useful for investors focused on fundamentally strong companies that are still undervalued relative to their historical performance.

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Footnotes

[1]"One up on wallstreet" - Peter Lynch, Chapter 13 (excerpt 1, excerpt 2)