An investor who has just started out often seeks the simplest method to gain amid stock market volatility. This is quite a common practice as they often find it challenging to pick the right stocks for their portfolio due to constantly changing market dynamics.
In the hunt for a winning strategy, they often end up picking the simplest form of value investing – the method of price-to-earnings ratio (P/E). More specifically, a P/E ratio of a stock can decide whether it is currently overvalued or discounted compared with the P/E of the market or peer group. If a stock’s P/E is higher than that of the market, one can conclude that it is an expensive bid and vice versa.
However, the problem arises when a stock apparently with an attractively lower P/E lacks growth catalysts. In such a case, if you buy the stock driven solely by its cheaper P/E, you might still end up paying more on the risk that the stock may falter soon. To avoid such value traps, Warren Buffett advises investors to focus on the earnings growth potential of a stock while judging the intrinsic value. Here lies the importance of a not-so-popular value investing metric, the PEG ratio.