The price/earnings to growth ratio also called the PEG ratio is a fundamental metric that can be used to broadly evaluate the value of a company. The PEG ratio is fairly similar to the price-to-earnings ratio but additionally takes the growth factor of the company’s earnings into account.
This essentially eliminates one of the primary flaws of the P/E ratio, which is the fact that it doesn’t tell anything about the future of a business but rather just compares the current market price with the present earnings of a company.
So what can be considered a good PEG Ratio?
A PEG ratio of below 1 can be beneficial, as it indicates that the stock is more undervalued given the future growth estimates of the company, while a PEG ratio of 1 often represents a fairly valued company, meaning that the P/E of a stock is equal to its growth rate.
The lower the PEG ratio, the more undervalued a company may currently be in regard to its expected earnings growth.
In order to calculate the PEG ratio, you’d need to divide the P/E of a stock with its estimated annual earnings-per-share (EPS) growth. The formula goes as follows:
Sometimes, a stock might have a negative PEG ratio, which can either mean that the underlying business currently produces negative earnings, or that the estimated growth rate is negative. Either way, a negative PEG ratio can be a very crucial red flag to take into caution when analyzing a business.
Peter Lynch, one of the most well-known investors, has popularized the PEG ratio and prefers to have companies that have higher growth aspects than their P/E ratio, which essentially concludes that you are paying less than the growth that you get when buying a business, whereas a company with a P/E ratio equal to its growth rate is considered fairly valued.
How to Use the PEG Ratio
One of the benefits of applying the PEG ratio is the use of distinguishing companies that might have a high P/E simply due to overvaluation, or because the market is willing to pay a premium for the underlying business as a result of their growth prospects. This clearly shows where the PEG ratio eliminates the primary flaw of the widely-used P/E ratio and why some investors prefer it over the simple price multiple.
Example
Suppose that there are two companies A and B, which both have the same P/E ratio of 15 but have different annual earnings growth rates. Company A’s earnings are estimated to grow 20% in the next year, while company B’s earnings are expected to grow 10% at most. From a P/E perspective, we wouldn’t be able to tell which company might be the better investment.
However, if we further assess the PEG ratio of each business, we would need to take each growth factors into account and come up with a PEG ratio of 0.75 for company A and 1.5 for company B. As a result, company A might make the better investment in terms of valuation since its multiple is lower than company B, despite the fact that both P/E’s remain the same.
The PEG Ratio Depends on Accuracy
While the earnings component of the PEG ratio shouldn’t be difficult to determine for calculation, the growth rate, however, can’t really be assessed with 100% accuracy. Nobody can exactly tell how the future is going to look like.
This is where the difficulties with the metric come into place. It can be challenging to estimate a realistic growth rate for a company, or completely rely on growth estimates from analysts. That being said, there are several ways to assess a range of growth rates which mostly turn out to be realistic to the individual business.
If you use the PEG ratio stated in a public source such as research sites like Yahoo Finance or Morningstar, you should always find out from which growth estimate the stated PEG ratio is derived from.
Most estimated growth rates are derived from assumptions by financial analysts. Those growth assumptions often turn out to be somewhat justified, however, you should always consider conducting your own research on how those growth estimates were assessed in the first place.
A rather simple way of determining a realistic growth rate for a company is to use the average earnings growth rate of the past 10 years of a business. This can effectively save you a lot of time but might also not be a reliable assessment for many companies that aren’t able to show consistent and predictable growth in their financial history.
Another caveat of the PEG ratio to be pointed out is simply the fact that other important financials such as dividends, cash flow, and debt are not taken into account of the PEG ratio.
Earnings aren’t necessarily the only factor that drives up stock prices. So even if a stock might look very attractive from a PEG ratio standpoint, solely making investment decisions based on the PEG ratio will likely not be enough.
Conclusion
Using the PEG ratio can definitely be a fairly accurate way of quickly assessing the value of a business. That being said, how attractive a stock is going to look from a PEG ratio perspective is heavily going to depend on the growth rate that you use in your calculation.
A very conservative growth estimate might leave you with a lot of hidden opportunities, whereas overestimated growth can lead to inaccurate valuation. The key to using the PEG ratio effectively relies on well-thought inputs, and the inclusion of other financial metrics and numbers of the business in your stock analysis.
