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A stock's price/earnings to growth (PEG) ratio may not be the first metrics that jump to mind when due diligence or stock analysis is discussed, but most would agree that the PEG ratio gives a more complete picture of stock valuation than simply viewing the price-earnings (P/E) ratio in isolation. (For related reading, see Move Over P/E, Make Way For The PEG.)
The PEG ratio is calculated easily and represents the ratio of the P/E to the expected future earnings growth rate of the company. This article will discuss the positive attributes of the metric, how to best use it in your research and what to watch out for when using it.
Determining a Stock's Value
Common stocks represent a claim to future earnings. The rate at which a company will grow its earnings going forward is one of the largest factors in determining a stock's intrinsic value. That future growth rate represents everyday market prices in stock markets around the world. The P/E ratio shows us how much shares are worth compared to past earnings. Most will use 12-month trailing earnings to calculate the bottom part of the P/E ratio. Inferences may be made by looking at the P/E ratio; for instance, high P/E ratios represent growth stocks, while low ones highlight value oriented stocks. (For more insight, read Understanding The P/E Ratio.)
Example - Calculating the PEG
Let's look at two hypothetical stocks to see how the PEG ratio is calculated:
ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years.
20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66
XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years.
30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75 |
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