What Is PEG Ratio?
The PEG ratio, also known as price/earnings to growth ratio is a valuation metric for defining the relation between the price of a stock, the earnings per share (EPS), and the company’s presumed growth.
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Generally, the P/E ratio for a higher growth rate company is higher so using only the P/E ratio would make high-growth companies seem overvalued relative to the others. It is found that by dividing the P/E ratio by earnings growth rate, the resulting ratio is better for relating companies with various growth rates.
The PEG ratio is viewed as a convenient approximation. It was first explained by Mario Farina in his 1969 Book “A Beginner’s Guide To Successful Investing In The Stock Market”.
PEG is a broadly applied indicator to get a stock’s possible fair value. Like the price-earnings ratio, a lower PEG means that the stock is undervalued and vice-versa.
How To Calculate PEG Ratio?
The formula for PEG ratio is;
PEG Ratio = Price-Earnings Ratio/Expected Growth Rate
If you’re picking two stocks from companies in a similar industry, then you might need to study at their PEG ratios to make your investment decisions. For instance, the stock of Company A may trade for a price that’s 10 times its incomes, while Company B’s stock may trade for 12 times its incomes. If you simply look at the Price-earning ratio, then Company A may seem like the more appealing and suitable.
However, Company A has a projected five-year earnings growth rate of 10% per year while Company B’s earnings have a projected growth rate of 15% per year for the identical period. Here’s the PEG ratio of both companies:
PEG of A = 10/10 = 1
PEG of B = 12/15 = 0.80
So with resultant PEG ratios company, B looks more suitable for investment having lower PEG then company A.
What Does the PEG Ratio Ratio Tell You?
While analyzing a stock with a low P/E ratio may look like a value buys, but factoring with the company’s growth rate to get the stock’s PEG ratio may tell a distinctive tale. With a lower PEG ratio, the stock may be undervalued with its healthy future profits expectations. Combining a company’s anticipated growth into the ratio helps to judge a company’s performance with a high P/E ratio.
The PEG ratio indicates the overvalued and undervalued stocks vary by industry and its type. According to analysts when a company’s PEG exceeds 1.0, it is regarded as overvalued or overpriced while a stock with a PEG of less than 1.0 is regarded as undervalued or underpriced. The ideal PEG ratio is 1.
PEG Ratio vs. P/E Ratio
The price-earnings ratio or P/E ratio gives investors a good basic indication of how much investors are currently paying for a stock with respect to the company’s income. However, the P/E ratio has one weakness that it does not take into record the future expected growth of a company during its calculation. While the PEG ratio represents an accurate valuation measure than the P/E ratio.
Including future growth adds an essential component to stock valuation since investments in the stock represent a financial interest in a company’s future incomes.
- The PEG ratio is less suitable for scaling companies without high growth. Big, mature companies, for example, may offer steady dividend income, but a small opportunity for growth.
- PEG ratio uses the future estimated growth, but the future growth of a company can vary due to many factors like market conditions, expansion problems, and hype of investors.
- While calculating PEG leaves out several important factors for simplicity and convenience. Like the absolute growth rate of a company used in the PEG does not account for the overall growth rate of the economy, and hence an investor must compare a stock’s PEG to average PEG’s across its industry to get more exact sense of how attractive a stock is for investment.
- A low PEG in events of high economic growth may not be expressly impressive when correlated to other stocks, and vice versa for high PEG’s during the economic slowdown and recession.
- Generally, companies having much higher than the economy’s growth rate are sensitive and exposed to any problems the company may face that would prevent it from keeping the growth in its current rate. Therefore, a higher PEG stock with a consistent, sustainable growth rate can be a more attractive investment than a low-PEG stock with a short-term growth strip.
- Another limitation of the PEG ratio is that in case of a highly volatile and speculative stock, that has lower price/earnings ratios due to low price, it is also not corrected for in PEG calculations.
Getting a reasonable PEG ratio mainly depends upon the factors that are used in the calculations. Investors and analysts may find that PEG ratios are fallacious if they use historical growth rates as future ones may deviate from the past. To find the distinct PEG most analysts often use “forward” and “trailing” PEG.