The PEG ratio is a metric used to analyze growth stocks. It assesses a stock’s price to its earnings level and growth rate of those earnings per share, in evaluating the appeal of the valuation.
Price/Earnings-To-Growth Ratio Meaning
The Price/Earnings-To-Growth ((PEG ratio)) is a financial metric that builds upon the price-to-earnings ratio (P/E ratio) to help investor assess the valuation of profitable growth stocks.
A company's price-to-earnings ratio is simply the price of its stock divided by the company's earnings per share. However, if two companies have the same price-to-earnings ratio but one company is experiencing 40% growth versus 10% growth for the other, the company with the higher growth by most assessments might be the more attractive investment.
Dividing a stock's P/E ratio by the company's growth rate helps investors incorporate expected future earnings into a measurable valuatio ratio. Investors should be mindful that no single valuation metric is a foolproof method for identifying undervalued stocks.
Tip: A stock with a low PEG ratio might not always be a better choice. High-growth companies are more likely to be volatile and have inconsistent earnings.
PEG vs. P/E Ratio
The P/E ratio of a company is calculated by taking a stock's price per share and dividing it by its annual earnings per share. This is done to determine what the ratio is between a company's annual earnings and its stock price. For example, if a stock earns $1.25 per share and has a stock price of $20 per share then the company's P/E ratio is 16x. That means that its share price is 16x its earnings.
A PEG ratio is reached by taking the P/E ratio and then dividing it by a company's growth rate over a specific period of time. For example, if the stock mentioned above grew 12% in the last year, its PEG ratio would be 1.33x (=16 / 12).
The PEG ratio includes a dimension that the P/E ratio leaves out, helping investors incorporate growth information into the valuation assessment.
Tip: There are online calculators that help determine the PEG ratio of a company.
Using The PEG Ratio Formula
The formula for calculating the PEG ratio is simple. Just divide the price/earnings ratio by the current (or forecasted) earnings per share growth rate.
Price Earnings Growth Ratio (PEG) = Price Earnings Ratio (P/E) / Earnings Per Share Growth Rate
Price/Earnings Growth Examples
Here is an example of how comparing the PEG ratio of two companies can be useful in understanding the company's value better.
Two different companies sell cars: Acme Cars has a share price of $100 and earnings per share of $5 and earnings growth 15%, while Beta Cars has a share price of $50 and earnings per share of $2 and growth of 25%.
- Price per share= $100
- Earnings per share this year = $5
- Price / Earnings ratio = $100 / $5 = 20x
- Growth = 15%
- PEG ratio = 20 / 15% = 1.333
- Price per share= $50
- Earnings per share this year = $2
- Price / Earnings ratio = $50 / $2 = 25x
- Growth = 25%
- PEG ratio = 25 / 25% = 1.0
In the above example, while Acme cars appears to have a lower P/E ratio (20x, versus 25x for Beta), Beta actually carries the more attractive PEG ratio, however, due to its higher growth rate.
Benefits & Limitations of the PEG Ratio
Pros of PEG
- Offers investors an extra dimension in comparing stocks: PEG ratios help investors compare stocks that are growing at different rates.
- Low PEG ratio stocks may yield faster declining P/E ratios: A reasonably high P/E stock may not look atractive right now, but if the PEG is low, and the company achieves growth expectations, the future P/E may look quite affordable using the current stock price.
- More meaningful than P/E ratio: A PEG ratio gives you a better understanding of a company's potential future value.
Pitfalls & Limitations of PEG
- Earnings might not continue to grow at the same rate: The PEG ratio assumes that earnings growth will remain constant for the foreseeable future. If there's a hiccup in the growth rate, a previous PEG measure may prove to be inadequate.
- Not meaningful for low growth stocks: While a PEG ratio may be useful in assessing stocks with higher growth rates, those with low growth do not at all fit well into this measure. For example, a stock with stable earnings and a P/E of 4x but just 1% growth will yield a relatively high PEG of 4x, despite that most investors would perceive a P/E of 4x to be highly undervalued and attractive.
- Growing companies can be more volatile: Companies that are growing rapidly are often more likely to miss investor expectations or stumble.
- Does not replace a deeper analysis: No single metric, regardless of whether it's P/E, PEG, P/B or other, can replace thoughtful and detailed company analysis. There may be key insights found in assessing a company's financial statements, leadership, and projections that wouldn't ever be reflected in a valuation metric.
PEG Ratio Interpretation For Investors
PEG ratios can be used to better understand whether a company is appropriately priced, underpriced, or overpriced relative to its future earnings and growth. Calculating a stock's PEG ratio can also be helpful in order to compare it to other companies in the same industry.
P/E ratios can be limiting in assessing the relative performance of a stock to competitors with different growth rates. The PEG ratio takes companies' different growth rates into account so that investors can better understand a stock's price relative to its potential for future growth. This helps investors find stocks that may be more likely to increase in value in the future.
Tip: As a quick reference point, traditionally many investors have used a PEG benchmark level of 1.0 to help them decide whether a stock is overvalued or undervalued. However, in truth not all stocks with PEG < 1.0 are overvalued, and not all stockes with PEG <1.0 are undervalued.
A PEG ratio is a useful metric investors can use to help assess a company's Price/Earnings ratio relative to expected growth. The use of any single metric, however, cannot replace the benefit of comprehensive analysis of a company's opportunities and risks.
This article was written by
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