Course 304: PEG and Payback Periods  
Payback Period = Double Your Money  

A payback period is the amount of time it takes for a company to accumulate enough in earnings to equal the amount of your original investment. That sounds complicated, but in simple terms, it is the time it would take you to double your money based on the profits a company is generating. There are a couple of payback periods to consider, and one of the simplest can be determined by looking at the stock's P/E, or the ratio of its price to its earnings per share. P/E is one way you can estimate how many years it would take for the company to accumulate earnings equal to its share price.
Imagine a $10 stock with $1 per share in earnings. Based on its P/E of 10 ($10/$1), if the company continues to earn $1 per share every year, it would take 10 years for all those dollars to add up to the original $10 stock price. So a stock with a P/E of 10 has a payback period of 10 years, assuming its earnings are the same each year.
But most companies don't make the same earnings year after year. As an investor, you're hoping the earnings will grow. To account for growth, there is something called the PEG payback period, which is based on the price/earnings growth (or PEG) ratio. The PEG ratio relates a company's price/earnings ratio (P/E) to its earnings growth. It is calculated by dividing a stock's forward P/E, or its P/E based on consensus analyst earnings estimates (what Wall Street analysts expect the company to earn over the next 12 months), by its forecasted earningsgrowth rate (the rate at which analysts expect the company to grow).
PEG ratio = forward P/E / expected growth rate
Like P/E, the PEG ratio tells you how many years it will take for earnings to equal the stock price. But unlike P/E, it assumes earnings will grow at a certain rate.
Take our $10 stock with $1 per share in earnings. If analysts' consensus estimates say the company will grow at a rate of 10%, we would increase each year's earnings by 10% before adding it up. Therefore, the first year's earnings would be $1.10 (that's $1 times 1.1), the second year's would be $1.21 ($1.10 times 1.1), and so on. Based on a 10% growth rate, it would take seven years before earnings added up to the original stock price. As you can see, the PEG payback period for any growing company will be shorter than the P/E payback period. (For a quick check of the PEG payback without all the calculations, check Morningstar's Quicktake Reports for individual stocks.)
Next: The Longer the Payback Period, the Greater the Risk >> 
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