The PEG Ratio or Price Earnings to Growth Ratio determines a stock’s value while considering future earnings growth.
Like the P/E Ratio, the PEG Ratio is used to get a better understanding of whether a company’s stock is overpriced, underpriced or right (priced).
The PEG Ratio uses the P/E Ratio of a company and compares it with that company’s annual growth rate.
If a company’s stock is priced, then its P/E Ratio should equal its annual growth rate.
PEG Ratio is calculated as = PE Ratio / Expected Earnings Growth (%)
- The P/E Ratio is the ‘Price to Earnings’ Ratio’
- The expected earnings growth will be in percentage form and is available from the company’s annual report.
- A PEG ratio of 1 suggests equilibrium between market value of stock and anticipated earnings.
- It means that the stock is priced, and current market price (numerator) justifies the anticipated growth rate (denominator).
For Example:
A company stock has a P/E of twenty. Analysts feel that the stock has anticipated earnings growth of 12% over the next five years.
PEG Ratio = 20 / 12 = 1.66
- Here, stock prices are higher than its earnings growth.
- This means that market price is higher compared to anticipated earnings growth.
- This can be attributed to ‘hype’ or undue enthusiasm in the market for that stock.
- To keep up with the market hype, the company will now have to grow faster.
- This means that if the company does not grow at a faster rate, the stock price will decrease (stock price correction will occur as hype will die down).
Another example…
- Another company’s stock has a P/E of thirty. Analysts feel that the stock has an anticipated earnings growth of 40% over the next five years.
PEG Ratio = 30 / 40 = 0.75
- Here, stock prices are lower than its earnings growth.
- This means that market price is lower compared to anticipated earnings growth.
- This tells us that the company’s stock is undervalued.
- Stocks are trading in line with the growth rate and the stock price has potential to increase in future.
Some thumb rules…
- PEG Ratio greater than 1 means:-
- The market’s expectation of growth is higher than analysts’ estimates.
- The stock is currently overvalued due to heightened demand for shares (investor hype).
- PEG Ratio less than 1 means:-
- Markets are underestimating the projected growth, and the stock is thus undervalued (a contra pick).
- Analysts’ estimates of future earnings growth are currently set too high.
Advantages of PEG Ratio…
- Investors prefer PEG because it puts a definite value in relation to the expected growth in earnings of a company.
- PEG ratio can offer a suggestion of whether a company’s high P/E ratio reflects an excessively high stock price or reflects promising growth prospects for the company.
Disadvantages of PEG Ratio…
- Less appropriate for measuring companies without high growth. Large well-established companies, for instance, may offer dependable dividend income but little opportunity for growth.
- A company’s growth rate is an estimate and is subject to limitations of projecting future events i.e., in this case estimated growth rate is only an estimate based on past trends.