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 ÷ 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.

Convention Statement
A document filed by an insurance or reinsurance company that ... 
Enterprise Value (EV)
A measure of a company's value, often used as an alternative ... 
Earned Premium
The amount of total premiums collected by an insurance company ... 
Insurance Regulatory Information System (IRIS)
A collection of databases and tools used to analyze the financial ... 
Book Value Reduction
Reducing the value at which an asset is carried on the books ... 
Deferred Tax Asset
A deferred tax asset is an asset on a company's balance sheet ...

What role does ratio analysis play in valuing a company?
Learn about the role of ratio analysis in determining company value, including some of the most common ratios used by modern ... 
What is the average pricetoearnings ratio in the oil & gas drilling sector?
Investing in the energy sector provides an opportunity for value investors, but it is necessary to understand metrics such ... 
Why is Average Collection Period important to a company?
Discover why the average collection period can be a particularly important accounting ratio for a company that relies heavily ... 
What is the purpose of drawing up a cash flow statement?
Understand the reasons behind why a company draws up a cash flow statement. Learn how it is used to understand the trends ...