Unlocking Investment Insights with the Price/Earnings-to-Growth (PEG) Ratio

Unlocking Investment Insights with the Price/Earnings-to-Growth (PEG) Ratio

The price/earnings to growth ratio (PEG ratio) stands out by dividing a stock’s price-to-earnings (P/E) ratio by its earnings growth rate over a specified time period. By considering earnings growth, the PEG ratio provides a more comprehensive view than the standard P/E ratio.

Key Takeaways

• The PEG ratio enhances the P/E ratio by including expected earnings growth.
• A lower PEG ratio suggests that a stock may be undervalued.
• The PEG ratio calculation can vary significantly, depending on the chosen growth estimate (e.g., one-year, three-year projected growth).
• Ideally, a PEG ratio lower than 1.0 indicates that a company is relatively undervalued.

How to Calculate the PEG Ratio

$PEG\; Ratio\; =\; Price/EPS\; \backslash \; EPS\; Growth\; \backslash \; \backslash \; ext\{where:\}\; \backslash \; EPS\; =\; ext\{The\; earnings\; per\; share\}$

To determine the PEG ratio:

1. First, calculate the P/E ratio, which is the company’s price per share divided by its earnings per share (EPS).
2. Next, obtain the expected earnings growth rate from available analyst estimates.
3. Divide the P/E ratio by the earnings growth rate to get the PEG ratio number.

Accuracy varies based on the data used. Consider using forward-looking growth estimates to better evaluate a stock’s potential.

What Does the PEG Ratio Tell You?

A low P/E ratio might initially indicate a good buy, but incorporating the company’s growth rate to calculate the PEG ratio could tell another story. A lower PEG ratio typically suggests the stock is undervalued given its future earnings projections. While acceptable PEG ratios can vary by industry or company type, ratios below 1.0 are often preferred.

Example of How to Use the PEG Ratio

Consider two hypothetical companies, Company A and Company B:

Company A:

• Price per share = $46
• EPS this year = $2.09
• EPS last year = $1.74

Company B:

• Price per share = $80
• EPS this year = $2.67
• EPS last year = $1.78

Given this information:

Company A

• P/E ratio: 46 / 2.09 = 22
• Earnings growth rate: (2.09 / 1.74) - 1 = 20%
• PEG ratio: 22 / 20 = 1.1

Company B

• P/E ratio: 80 / 2.67 = 30
• Earnings growth rate: (2.67 / 1.78) - 1 = 50%
• PEG ratio: 30 / 50 = 0.6

While Company A may appear attractive due to its lower P/E ratio, Company B, with its lower PEG ratio, provides better value relative to its earnings growth rate.

What Is Considered to Be a Good PEG Ratio?

Generally, a PEG ratio below 1.0 is desirable, indicating the stock may be undervalued. On the other hand, PEG ratios above 1.0 may suggest overvaluation.

What Is Better: A Higher or Lower PEG Ratio?

Lower PEG ratios are generally more favorable, especially those under 1.0.

What Does a Negative PEG Ratio Indicate?

A negative PEG ratio, resulting from either negative earnings or a negative growth estimate, suggests potential company difficulties and warrants caution.

The Bottom Line

Though the P/E ratio remains a staple for many investors, the PEG ratio offers a fuller picture by incorporating earnings growth. Accurate growth estimates are crucial for reliable PEG ratios. A misguided forecast or over-reliance on historical growth can produce misleading results.

Related Terms: P/E Ratio, Earnings Growth, Stock Valuation, Investment Analysis.

References

1. Morgan Stanley Wealth Management. “An Introduction to Stock Analysis”. Page 2.
2. Peter Lynch and John Rothchild. One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. Simon & Schuster, 2000.

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