Price/Earnings-to-Growth or PEG Ratio Definition
The PEG ratio is a metric used to determine the trade-off between the stock’s price, the earnings it will generate, and the growth rate expected by the company. If a company has a high growth rate, then it is expected that the price/earnings ratio will also be high.
Therefore, the use of P/E ratios alone would make the companies with high growth rates appear overvalued. When the P/E ratio is divided by the company’s growth rate, it provides a better comparison for the different growth rates.
A Little More on What is a PEG Ratio
PEG ratio is an improved type of the P/E ratio as it factors in the growth earnings of a company. Investors and analysts make use of price/earnings to growth ratio to value a company’s shares. It also helps them know the growth history of the company over time. Investors are likely to invest in companies with high PEG ratios because they expect higher growth rates in the future.
Calculating the PEG Ratio
PEG Ratio = (Stock’s price divided by EPS). You divide this by the growth rate of the earnings.
EPS refers to Earnings per share. For an investor to calculate the PEG ratio, he first needs to calculate the P/E ratio.
The accuracy of any ratio is dependent on the type of inputs used, and the accuracy of the PEG ratio. It is always important to find the growth rate used for a certain PEG calculation. Some websites provide information on the growth rates of stocks. An example is Yahoo! Finance, which uses the current year’s data and an expected 5-year growth rate to calculate PEG. This will provide a more accurate PEG than using past growth rates. The terms forward PEG and trailing PEG are used to differentiate growth rate calculations.
Forward price to earnings uses indicators based on future earnings of the company. This gives a clear picture of what the investors should expect in the future. Trailing price to earnings, on the other hand, uses indicators from the past 12 months to calculate the PEG ratio.
An example of PEG Ratio calculation
Take an example of the stock of Company ABC. Assume ABC is doing business with a price/earnings ratio of 30. Many investors will consider this a costly stock. But, we can also assume that the analysts have predicted a growth rate of +40% per share in the coming year. Here, the PEG ratio of Company ABC would be;
PEG ratio = 30 / +40 % (growth earnings) which is equal to 0.75
A PEG ratio that is lower than 1 is well-thought-out as a good value. The P/E value for ABC is high. But, according to its PEG ratio, it has been undervalued as it has high growth potential.
A good PEG Ratio
Investors and analysts make use of the PEG ratio to assess the performance of a company and evaluate the risks associated with an investment. Any PEG ratio with a value 1 indicates that the market value and earnings growth of the company have a perfect connection.
PEG ratio that is higher than 1 indicates that the stock has been overrated and is unfavorable in the market. On the other hand, PEG values less than 1 show that the stock has been under-priced. They are considered a better option than high PEG ratio values.
There are cases where the PEG ratio may have a negative value. This can happen when;
- In the past years, the company had lost a significant amount of money.
- The company is making profits, but the profits are going to reduce drastically in the future.
It is important to note that a negative PEG ratio, does not mean that investing in the stock is a bad idea. It simply requires an investor to first analyze the stock critically before making the final decision.
Uses of PEG ratio
Used to determine the stock value depending on the growth patterns of the company. The prices of a stock are inclined to demand, speculation, and investor expectations.
PEG ratio helps analysts to value a company depending on its products and adjust its value so that it can keep growing. There isn’t a standard for measuring an investment as different companies have varying growth rate earnings.
Disadvantages of using PEG
A few aspects have to be put into consideration before using the PEG ratio to trade off stock. These include;
The assumptions made when calculating the PEG ratio may not be valid. The example above assumes the projected growth rate for the following year. This is not a long time, but no one can tell whether the growth rate could speed up or slow down. Factors such as expansion setbacks and market conditions can affect the growth of a company. This may take more than the anticipated time.
Some variables are not factored in when calculating the PEG ratio. These variables could add to or reduce the value of the company. An example, some companies have balance sheets that have a lot of money. This is never accounted for when calculating the PEG ratio.
The use of ancient growth rates may give an inaccurate price/earnings to growth ratio. This especially happens when future growth rates diverge from past growth rates.
A stock price that is cheap and affordable can make a good investment for any investor. The investor needs to analyze the PEG ratio or any metrics used before buying the stocks. These metrics help bring out the structure of the investment process.