P/E to Growth Ratio
introduction to PEG Ratio
The PEG ratio, often called Price Earnings to Growth, is a valuation metric. It measures the value of a stock based on the current earnings and the potential future growth of the company. In simple words, it is a way for investors to calculate whether a stock is over priced or under priced by considering the earnings today and the future growth rate of the company.
definition- What is peg ratio?
- PEG ratio was originally developed by Mario Farina and latter populalized by Peter Lynch. It is an improved version of the P/E ratio because it factors in the growth of the company by dividing the P/E by the annual growth rate.
- The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E alone.
- In other words, the PEG ratio allows investors to calculate whether a stocks price is overvalued or undervalued by analyzing both today’s earnings and the expected growth rate for the company in the future.
- The P/E ratio does not factor in future earnings growth. Thus, the PEG ratio provides more insight into a stock’s valuation. By providing a forward-looking perspective, the PEG is a valuable tool for investors in calculating a stock’s future prospects.
- For eaxmple, by looking at P/E ratio, a stock might look attractive, since P/E ratio doesn’t consider where the company will be at in the future. In reality, the company’s growth pattern might be stagnant. When taking this into consideration, the stock might actually be a bad buy.
- PEG ratio is calculated by dividing Price Earnings by the Annual Earnings per Share Growth Rate.
- PEG Ratio = [ P/E Ratio / Annual EPS Growth Rate ]
- P/E ratio measures the current share price of the company relative to its Earnings per share or EPS.
- EPS is the portion of a company’s profits for a period that are allocated to each no. of outstanding shares of common stock. Here, outstanding shares include stock owned by the public as well as restricted shares owned by the company’s officials and employees.
There are 2 methods for determining PEG Ratio : Forward PEG & Trailing PEG
- Forward PEG = [ P/E Ratio / Expected Future Growth Rate ]
In Forward PEG, we need to use a forward-looking growth rate for a company. This number would be an annualized growth rate (i.e. % earnings growth per year)
2. Trailing PEG = [ P/E Ratio / Trailing Growth Rate ]
The trailing growth rate could be derived from the last fiscal year, the previous 12 months or some sort of multiple-year historical average.
What does PEG Ratio tell?
- The PEG ratio is used to figure out whether a stock price is over or undervalued based on the growth patterns of the business in its industry. It’s a value calculation to see what the company is actually worth regardless of what the stock is currently trading for.
- Investors expectations, demand and speculation all influence a company’s stock price. A completely worthless company could have a high stock price because investors keep pushing the price up.
- PEG aims to value the company based on what it produces and adjust that for the growth of the company. Since companies’ earnings and growth potential vary greatly among industries, there isn’t a standard number that indicates a good or bad investment.
- The inventor Peter Lynch stated that the PEG ratio of any company which is fairly priced is equal to 1.
- So, though the standard PEG rate of companies for valuation purpose varies with the industry. It is safe to say as a thumb rule that “the companies with the PEG ratio of less than 1 are better or good buy because the stock price is undervalued. And the companies with PEG more than 1 are worse or expensive.”
- A low P/E ratio compared to the sector’s average P/E ratio may indicate that the company is undervalued and a good buy, factoring in the company’s growth rate and using PEG ratio may tell a complete story.
- Generally speaking that the P/E growth is higher for a company with a higher growth rate. Thus, using just P/E ratio for companies with high growth rate may make them look overvalued relative to others. So, by using the PEG ratio, we are saying that by dividing the P/E ratio with the growth rate, we are getting a ratio which is a better way of comparing companies with different growth rates.
- The use of P/E as a valuation metric is quite straightforward. A P/E ratio of 30 means that a company’s stock price is trading at 30 times the company’s earnings per share.
- In a way, we are simply scaling the P/E ratio by the growth rate. So, a PEG ratio tells us whether the high P/E ratio an excessively high stock price or is a promise of sustainable high growth rates in the future.
- The use of PEG ratio for companies with of extreme growth rate say low growth rates is extremely questionable because it can make look that company overvalued. So, the PEG ratio is mostly used for those companies who are growing significantly faster than the earnings.
- Also, understand that the company’s growth rate is just an estimate. This estimate is subjected to the limitations of projecting future events and it can change due to a no. of factors like market conditions, expansion setbacks and hype of investors.
- The absolute company’s growth rate used for the company doesn’t account for the growth of the economy. So, the investor must compare a stock’s PEG with the industry average PEG ratio to get a better sense of how attractive the stock is for investment.
- In addition, company growth rates that much higher than the economy’s growth rate is unstable and vulnerable to any problems the company may face. Therefore, a higher-PEG stock with a steady, sustainable growth rate (compared to the economy’s growth) can often be a more attractive investment than a low-PEG stock that may happen to just be on a short-term growth “streak”, which is a major disadvantage of the ratio.
- The PEG ratio has no implicit or explicit correction for inflation. So, for example, if the growth rate for the company is equal to the inflation rate, the company is not growing at all in real terms. Hence, the PEG ratio lacks a comprehensive framework due to this.
PEG RATIO EXAMPLES as on 24th march, 2019
- The PEG ratio enhances the P/E ratio by adding in expected earnings growth into the calculation. The PEG ratio is considered to be an indicator of a stock’s true value, and similar to the P/E ratio, a lower PEG may indicate that a stock is undervalued
- Though PEG is an improved version of the P/E ratio, it doesn’t make P/E a useless comparison. Most investors use both of these calculations for different reasons. It’s important to not rely on one calculation too heavily in any investing situation. Each metrics gives a little more information about whether the investment is a good one or not. It’s important to look at all of them.
- Stock prices are typically based on investor expectations of future performance by a company. So the PEG ratio can be helpful but is best used when comparing if a stock price is overvalued or undervalued based on the growth in the company’s industry.