Investors use fundamental analysis to determine a stock’s actual price and use several financial ratios to facilitate it. One of the metrics that investors use is the Price/Earning ratio. But there is one more metric that is more useful than the P/E ratio. It is called the PEG ratio or Price/Earning-to-Growth ratio. What does it do? We will explain this in this article.
What is the PEG ratio?
The PEG ratio compares the stock’s price with its earnings and factors in the projected earning growth rate over a specified period. Hence, the PEG ratio packs more information regarding the stock than the price-to-earnings ratio. It indicates the actual value of a stock, and similar to the PE ratio, it signifies if the stock is undervalued or not. For example, a lower PEG ratio indicates an undervalued stock. However, it is a little unstable because the potential value of PEG depends on which growth estimate is used and based on that, the PEG value will differ.
How to Calculate the PEG Ratio?
The PEG ratio formula is pretty straightforward. It requires individuals to divide the PE ratio of the company by the expected growth rate for a specified period.
PEG Ratio = Price to Earnings Ratio / Earnings Per Share (EPS) growth rate
Where:
EPS = The earning per share
Here is a simplified example of how to measure the PEG.
Suppose a company has a PE ratio of 18, which is expected to grow at 10%. The PEG ratio of the company is (18/10) or 1.8%. However, there are complexities in calculating the PEG ratio.
To calculate a PEG, the investor needs three values
- Share price
- Earning per share
- Expected future growth
Here the share price is the current market price which is easy to determine. The complexities arise in deciding the earnings per share and the expected growth rate
As mentioned above, PEG denotes a ratio between P/E and projected growth in earnings. Hence, it is a trailing version of the PE ratio, not the forward one. The critical factor is to assess its value.
A company that is expected to grow at a higher rate, and increase its revenue, cash flow and earnings more rapidly than its peers while the other factors remain the same, is more valuable. It is why a growth company has a higher PE ratio than a value company, and investors usually pay a higher price for a growing company. But the question remains: how much should investors pay for the growth? The ‘growth at any cost’ approach can lead to a significantly higher price, even for a great company. The PEG ratio can help investors put a price on the company’s growth rate.
There are two ways to determine the earnings of the company. The most common approach is to use the company’s profits from the past, usually called TTM or the trailing twelve-month value. The TTM value is mentioned in the company’s financials. Hence, it doesn’t require an estimation. However, in hindsight, the TTM value doesn’t reflect the company’s future prospects.
Secondly, complexities arise in measuring the expected growth rate value, which requires a fair estimation. Investors can base the calculator of future growth rate based on the company’s past performance, but one should consider if the future growth is indicative of the company’s future growth. There is a fair possibility that future growth will slow down or quicken depending on economic factors. As a result, a PEG ratio is calculated using different assumptions, which lead to different results.
How to Interpret the PEG Ratio?
A new metric for assessing a stock’s price that accounts for predicted profit growth rate is the Price/profits to Growth ratio or PEG ratio. The PEG ratio offers a growth perspective, whereas the traditional Price/profits (P/E) ratio shows the cost per rupee of a stock’s profits. In a simple P/E ratio comparison, a lower figure is often preferred over a greater one.
However, when factoring in the projected growth rate, as exemplified by two stocks, A and B, the PEG ratio becomes pivotal. If stock A exhibits a P/E ratio of 20 and an estimated EPS growth rate of 18%, its PEG ratio is calculated as 1.11. On the other hand, stock B, with a P/E ratio of 25 and a growth rate of 30%, has a PEG ratio of 0.83. Despite stock A having a lower P/E ratio, the PEG ratio reveals the market’s overestimation of its earning potential, making it overvalued, while stock B, with a higher P/E ratio, appears undervalued when considering future income projections.
A PEG ratio of 1 represents a balance between a stock’s perceived value and earnings potential. Ratios more than 1 indicate an overestimation of value compared to growth, suggesting overvaluation, whilst ratios less than one imply an underestimation, indicating undervaluation. It is critical to contextualise PEG ratio conclusions within industry and business contexts since values over or below 1 might represent investor attitudes and external market variables driving demand for a certain stock.
What is a good PEG value?
Like PE, the PEG ratio is also an indicator. Investors use the PEG value to determine if a stock is reasonably priced or undervalued. As a rule of thumb, a PEG value of 1 or below suggests a good undervalued stock. Investors who use the PEG ratio also use the PE ratio during decision-making. When both values are low, it is usually a desirable stock investment.
Investors use PEG ratios to compare companies concerning their future growth. But given the uncertainties in predicting a company’s future growth, one shouldn’t look into the PEG ratio alone. Hence, it is one of the many factors used by investors in evaluating a potential investment.
For most investors, a PEG value below 1.00 is desirable. According to celebrated investor Peter Lynch, a PEG value of 1 denotes equilibrium. It reflects a balance between the stock’s worth and its earning potential.
When to use the PEG ratio?
The PEG ratio allows investors to compare multiple stocks to determine the best one regarding future growth potential. For example, companies X and Y have PE ratios of 20 and 22, respectively. If investors look only at the PE ratio, then company X looks like a good investment option. However, company X has a projected growth rate of 19%, whereas the same is 27% for company Y.
Company X= 20/19 or 1.09
Company Y= 22/27 or 0.81
Company X has a higher PEG, meaning its stocks are overvalued. However, the PEG value of company Y is less than 1, meaning its stocks are trading at a discount. So, PEG allows one to make informed investment decisions.
However, as you might have noticed, the inference from the PEG ratio should always be in the context of industry, company type, and others.
Advantages of PEG ratio
- Holistic Assessment: The PEG ratio combines the P/E ratio and earnings growth rate, offering investors a nuanced understanding of a stock’s value by harmonising current earnings with future growth potential. This comprehensive approach enables well-informed investment decisions, providing a precise gauge of a stock’s potential.
- Comparative Understanding: PEG ratios make it easier to compare businesses operating in the same sector. Investors may identify cheap stocks with significant growth potential by normalising the P/E ratio with growth rate, which enhances their capacity to make well-informed investing selections.
- Risk Evaluation: The PEG ratio assists investors in assessing a stock’s risk by indicating its undervaluation concerning growth prospects. A low PEG ratio signals an advantageous risk-to-reward ratio, empowering investors to proficiently manage their risk exposure. Identifying undervalued stocks with strong growth potential allows investors to make strategic decisions, maximising returns while minimising associated risks.
- Extended Horizon: Prioritising earnings growth in the long run, the PEG ratio promotes a strategic approach to long-term investing. Aligning decisions with a stock’s future earnings potential allows investors to adopt a patient and deliberate investment strategy.
- Effective Screening: PEG ratios are incredibly effective screening instruments that let investors find equities with strong growth potential at affordable prices very fast. This expedites the process of choosing stocks, saving time and energy that would otherwise be required for investigation and evaluation.
Disadvantages of the PEG ratio
- Dependency on Future Predictions: The PEG ratio’s effectiveness is dependent on exact earnings growth estimates. Relying on these projections carries a considerable risk because they may not always occur as expected, resulting in erroneous valuations and perhaps misdirected investment decisions. Investors should recognise the inherent uncertainty in estimating future profit growth since any disparities can cause considerable variances in the computed PEG ratio.
- Neglects Company-Specific Variables: The PEG ratio’s notable drawback is its oversight of crucial company-specific factors like management quality, competitive advantages, and market dynamics. Assuming firms with similar PEG ratios are identical can lead to errors in evaluating a company’s distinct qualities. Consequently, investors might make decisions based solely on the PEG ratio without considering essential individual factors, potentially resulting in suboptimal investment choices.
- Limited Applicability Across Industries: The comparability of the PEG ratio is hindered by varied growth patterns in different sectors. Using a uniform PEG threshold may lead to inaccurate assessments and challenges in cross-industry valuations. Investors should exercise caution in cross-industry PEG ratio comparisons, recognising its limitations. A comprehensive analysis, considering industry-specific factors, is crucial for informed investment decisions.
PEG Ratio vs P/E Ratio
| Parameters | PE ratio | PEG ratio |
| Definition | It indicates a ratio between the company’s market price and earnings per share. | The PEG calculates the company’s PE ratio and projected EPS growth rate. |
| Nature | One can calculate the PE ratio on the historical values, forward-looking, or hybrid. | It is often based on historical values. |
| Type | Two types – trailing and forward-looking. | There is only one type of PEG. |
| Interpretation | PE is more than 1 implies the market’s readiness to pay a higher price for Rs 1 of its earnings. | A PEG value of more than 1 means the stock is overvalued and vis-a-vis. |
The bottom line
PEG offers a fuller picture by incorporating the growth prospect into the company’s earnings. Understanding the PEG ratio meaning lets you explore the market more deeply. It is always better to get more information before you invest than to make blind guesses in the stock market.
FAQs
Which PEG ratio is better?
The determination of which PEG ratio is better depends on various factors, including industry context, risk tolerance, and market conditions. Generally, a lower PEG ratio is perceived favourably, indicating potential undervaluation. However, it’s crucial to consider industry norms and specific company factors. Investors should consider the larger context and utilise the PEG ratio as part of thorough research to make educated decisions.
How is the PEG ratio calculated?
The PEG ratio, or Price/Earnings to Growth ratio, is calculated by dividing a stock’s Price-to-Earnings (P/E) ratio by its earnings growth rate. For instance, if a stock has a P/E ratio of 20 and an estimated earnings growth rate of 15%, the PEG ratio would be 20/15, resulting in 1.33.
Is the PEG ratio better than the PE ratio?
The PEG ratio incorporates a stock’s growth potential, providing a more nuanced valuation compared to the PE ratio. While the PE ratio gauges a stock’s current valuation based on earnings, the PEG ratio adjusts for future earnings growth. Investors often use both metrics, considering the PEG ratio for a broader assessment of a stock’s potential, but each has its merits depending on investment preferences and objectives.
What is a good PEG ratio?
A PEG ratio of roughly 1 is typically regarded as appropriate since it represents a balance between a stock’s price, current profits, and future growth potential. A PEG ratio below 1 is sometimes seen as possibly cheap, implying that the market has not completely accounted for predicted profit growth.
