Investment Valuation Ratios: Price/Earnings To Growth Ratio
By Richard Loth (Contact  Biography)
The price/earnings to growth ratio, commonly referred to as the PEG ratio, is obviously closely related to the P/E ratio. The PEG ratio is a refinement of the P/E ratio and factors in a stock's estimated earnings growth into its current valuation. By comparing a stock's P/E ratio with its projected, or estimated, earnings per share (EPS) growth, investors are given insight into the degree of overpricing or underpricing of a stock's current valuation, as indicated by the traditional P/E ratio.
The general consensus is that if the PEG ratio indicates a value of 1, this means that the market is correctly valuing (the current P/E ratio) a stock in accordance with the stock's current estimated earnings per share growth. If the PEG ratio is less than 1, this means that EPS growth is potentially able to surpass the market's current valuation. In other words, the stock's price is being undervalued. On the other hand, stocks with high PEG ratios can indicate just the opposite  that the stock is currently overvalued.
Formula:
Components:
For the numerator, we are using Zimmer Holdings' P/E ratio, as calculated in the last chapter, for its fiscal yearend, December 30, 2005. The denominator, estimated earnings per share growth in 2006, is based on data found in a Value Line stock report on Zimmer Holdings.
Variations:
None
Commentary:
While the P/E ratio represents a very simple and widely used method of valuing a stock, it does lack one very important variable. The assumption with high P/E stocks (generally of the growth variety) is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio helps investors determine the degree of reliability of that growth assumption.
Although the PEG ratio improves upon (i.e. provides additional valuation insight) the P/E ratio, it is still far from perfect. The problem lies with the numerator and the denominator in the equation. Misreading of a company's and/or analysts' predictions of future earnings are very common. Also, investor sentiment regarding a stock's pricing and earnings prospects is usually overly optimistic during bull markets and overly pessimistic in bear markets.
The question of where investors can source the data necessary to calculate the PEG ratio focuses entirely on the estimated future growth of pershare earnings. A stock's P/E ratio appears in virtually all price quotes regardless of their origin. Estimated earnings growth shows up in investment research reports and financial analysts' comments in the financial press but may require some digging to find it.
In this regard, the historical and estimated performance of a company's earnings per share is easily obtained from Value Line stock reports, which are available by subscription to the Value Line Investment Survey. It should also be noted that most public libraries carry a Value Line subscription, which, therefore, makes its stock reports available free of charge to the general public.
Using Zimmer Holdings as an illustration, let's take a look at the data in question in a December 1, 2006 Value Line stock report on the company. At the top of the report, Value Line reports a trailing P/E ratio of 22.6. Zimmer Holdings went public in 2001, so we have five years of actual EPS, as well as Value Line's one, two, and threetofive year EPS estimates in the per share data box.
Value Line estimates a +11% EPS growth for the 20052006 period and +14% growth rate for 2007. So, at yearend 2006 we are looking at a PEG ratio for Zimmer of 1.61 (22.6 P/E ratio รท 14% EPS growth). Some peer company PEG ratio comparisons would give investors an idea of the strength or weakness of this valuation indicator at that point in time.
To learn more, check out Understanding The P/E Ratio,Analyze Investments Quickly With Ratios and Move Over P/E, Make Way For The PEG.

ShortTerm Debt
An account shown in the current liabilities portion of a company's ... 
Audit
An unbiased examination and evaluation of the financial statements ... 
IRR Rule
A measure for evaluating whether to proceed with a project or ... 
Profit and Loss Statement (P&L)
A financial statement that summarizes the revenues, costs and ... 
Discounted Payback Period
A capital budgeting procedure used to determine the profitability ... 
Selling, General & Administrative Expense  SG&A
Reported on the income statement, it is the sum of all direct ...

What items on the income statement are considered in fundamental analysis?
Fundamental analysis is a valuation method that equity investors use. Fundamental analysts attempt to establish the intrinsic ... Read Full Answer >> 
How can I tell whether a particular small cap stock has a positive investment outlook?
The investment outlook for a smallcap stock is determined by operational outlook and current stock price. The operational ... Read Full Answer >> 
Which financial statements are most important when performing ratio analysis?
Financial ratio analysis is an important aspect of fundamental analysis for any party engaged in value investing. Financial ... Read Full Answer >> 
What role does ratio analysis play in valuing a company?
Ratio analysis is an important part of contemporary investment valuation. This is true whether the investment is an issued ... Read Full Answer >> 
What is the average pricetoearnings ratio in the oil & gas drilling sector?
The energy sector provides unique opportunities for individuals interested in value investing, especially with companies ... Read Full Answer >> 
What is finance?
"Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>