The PEG ratio is a financial ratio that is used to compute a company’s expected growth. It is calculated by taking the price per earnings ratio and dividing it by the earnings growth rate over one to three years. The PEG ratio is the P/E ratio adjusted to take into account the growth rate in earnings per share (EPS) anticipated in the future. It provides a complete picture of the stock’s value versus standard P/E ratios.
A company anticipates growing its earnings, cash flow, and revenue at a higher rate than a company with fewer opportunities to grow. Value companies often have lower P/E ratios than growth companies. For these reasons, investors are ready to pay more for future growth. High near-term valuations do not necessarily pose a problem when investors see the growth potential.
How much then are investors willing to pay for growth? Using the change at any cost approach can lead one to overspend on a great company. However, the PEG ratio can help an investor decide the price on a company’s growth rate.
PEG Ratio Calculations
What is needed to calculate the PEG ratio:
- Earnings per share
- Stock price
- Expected earnings growth
The PEG ratio is calculated by dividing the company’s P/E ratio by the anticipated growth rate.
The trailing P/E ratio is used for the calculation of the PEG ratio.
PEG Ratio Formula
PEG = Price to Earnings Ratio / Earnings Growth Rate
Let’s look at the following example.
A company has a P/E ratio of 18 and a expected earnings growth rate of 12% per year. The PEG ratio will be:
PEG = 18/12 = 1.5
Because the company’s PEG ratio is more than one, many investors would shy away from this investment. The growth rate in the denominator is treated as a general number and not as a percentage.
A stretch through different periods can be used in the estimations of a company’s growth rate. The period could be between 1-3 years. However, the chances of the result being inaccurate increase as the number of years increases.
Investors can refer to the company’s declared estimates to get the growth estimates. They can also employ the use of projections published on analysts’ websites.
Features of an Ideal PEG Ratio
Peter Lynch, a prominent value and financial investor, argues that a company’s price to earnings ratio and projected growth rate should support a PEG of 1.0, which is the equilibrium.
A PEG ratio below one is said to mean a stock has been undervalued, thus a good buy, whereas a PEG ratio of more than one could infer a stock is overvalued and should be avoided. Therefore, investors who use the PEG ratio to look for stocks with a price to earnings ratio of greater or equal to a company’s expected growth rate.
Just because a company’s PEG ratio is greater or lesser than one does not means it is a bad or good investment.
The PEG ratio comes in handy when equating similar companies to their growth prospects. However, the PEG ratio should be used together with other investment evaluating metrics due to the uncertainty of the estimates used to calculate the PEG ratio.
Interpreting PEG Ratios
High P/E ratio values may indicate a stock is not a good value due to overvaluation. However, after calculations, the stock’s PEG report may yield low numbers if it has a reasonable growth rate, meaning the stock may still be a profitable venture.
On the other hand, a stock with low P/E may be assumed to be undervalued. However, if the company’s earnings do not project a reasonable growth rate, the PEG report might yield a higher number, indicating the stock is not a good investment.
Limitations of PEG Ratio
PEG ratios employ assumptions that may turn out to be accurate or not accurate. The metrics used in calculating PEG ratios are founded on someone’s beliefs about what might happen.
The PEG ratio also does not consider other variables that could take away from or add to the company’s value. For instance, the PEG ratio ignores the value the cash kept on some growth companies’ balance sheets can add.
The PEG ratio is a more meaningful measure of value than the P/E ratios. An investor can evaluate the price of a company concerning its potential for future earnings growth.
The PEG ratio offers valuable data to compare companies and decide on a stock that best suits an investor’s needs. Although the PEG ratio is a useful tool for evaluating a potential investment and the uncertainty of a company’s growth rate, it should not replace the fundamental analysis of a company’s management, financial statement, industry, and other vital factors.
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