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When computing the PEG ratio for a stock, how is a company's earnings growth rate determined?

Remember that the price/earnings to growth ratio (PEG ratio) is simply a given stock's price/earnings ratio (P/E ratio) divided by its percentage growth rate. The resulting number expresses how expensive a stock's price is relative to its earnings performance.

For example, let's say you're analyzing a stock trading with a P/E ratio of 16. Suppose the company's earnings per share (EPS) have been and will continue to grow at 15% per year. By taking the P/E ratio (16) and dividing it by the growth rate (15), the PEG ratio is computed to be 1.07. But things are not always so straightforward when it comes to determining which growth rate should be used in the calculation. Suppose instead that your stock had grown earnings at 20% per year in the last few years, but was widely expected to grow earnings at only 10% per year for the foreseeable future. To compute a PEG ratio, you need to first decide which number you will plug into the formula. You could take the future expected growth rate (10%), the historical growth rate (20%) or any kind of average of the two.

Let's explain the two methods that are commonly used. The first is to use a forward-looking growth rate for a company. This number would be an annualized growth rate (i.e. percentage earnings growth per year), usually covering a period of up to five years. Using this method, if the stock in our example was expected to grow future earnings at 10% per year, its forward PEG ratio would be 1.6 (16 divided by 10). You might also see people using another method, in which the stock's trailing PEG ratio is reported, calculated by using trailing growth rates. The trailing growth rate could be derived from the last fiscal year, the previous 12 months or some sort of multiple-year historical average. Turning again to the stock in our example, if the company had grown earnings at 20% per year for the past five years, we could use that number in the calculation, and the stock's PEG would be 0.8 (16 divided 20).

Neither one of these approaches to PEG ratio calculation is wrong - the different methods simply provide different information. Investors are often concerned about what price they are paying for a stock relative to what it should earn in the future, so forward growth rates are often used. However, trailing PEG ratios can also be useful to investors, and they avoid the issue of estimation in the growth rate since historical growth rates are hard facts.

Regardless of what type of growth rate you use in your PEG ratios, what matters most is that you apply the same method to all the stocks you look at, to ensure that your comparisons are accurate. You should also bear in mind that PEG ratios will vary by industry and company type, so there is no universal standard for PEG ratios that determines whether a stock is under- or overpriced. Generally speaking, however, a PEG ratio of less than 1 suggests a good investment, while a ratio over 1 suggests less of a good deal. Remember, PEG ratios don't tell you anything about the future prospects of a company (i.e. a company sure to go bankrupt will likely have a very low PEG ratio, but that doesn't mean it's a good investment).

For further reading, check out Move Over P/E, Make Way For The PEG and How The PEG Ratio Can Help Investors.

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