What Is the Price/Earnings-to-Growth – PEG Ratio?
The PEG ratio is used to determine a stock's value while also factoring in the company's expected earnings growth and is thought to provide a more complete picture than the P/E ratio.
The Formula for the Price/Earnings-to-Growth (PEG) Ratio Is
- The PEG ratio enhances the P/E ratio by adding in expected earnings growth into the calculation.
- The PEG ratio is considered to be an indicator of a stock's true value, and similar to the P/E ratio, a lower PEG may indicate that a stock is undervalued.
- The PEG for a given company may differ significantly from one reported source to another, depending on which growth estimate is used in the calculation, such as one-year or three-year projected growth.
How to Calculate the PEG Ratio
PEG Ratio=EPS GrowthPrice/EPSwhere:EPS = The earnings per share
To calculate the PEG ratio, an investor or analyst needs to either look up or calculate the P/E ratio of the company in question. The P/E ratio is calculated as the price per share of the company divided by the earnings per share (EPS), or price per share / EPS.
Once the P/E is calculated, find the expected growth rate for the stock in question, using analyst estimates available on financial websites that follow the stock. Plug the figures into the equation, and solve for the PEG ratio number.
As with any ratio, the accuracy of the PEG ratio depends on the inputs used. When considering a company's PEG ratio from a published source, it's important to find out which growth rate was used in the calculation. Yahoo! Finance, for example, calculates PEG using a P/E ratio based on current-year data and a five-year expected growth rate.
Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from a company's historical growth. The ratio can be calculated using one-year, three-year, or five-year expected growth rates, for example.
To distinguish between calculation methods using future growth and historical growth, the terms "forward PEG" and "trailing PEG" are sometimes used.
What Does the Price/Earnings-to-Growth Ratio Tell You?
While a low P/E ratio may make a stock look like a good buy, factoring in the company's growth rate to get the stock's PEG ratio may tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its future earnings expectations. Adding a company's expected growth into the ratio helps to adjust the result for companies that may have a high growth rate and a high P/E ratio.
The degree to which a PEG ratio result indicates an over or underpriced stock varies by industry and by company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is desirable.
According to well-known investor Peter Lynch, a company's P/E and expected growth should be equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company's PEG exceeds 1.0, it's considered overvalued while a stock with a PEG of less than 1.0 is considered undervalued.
Example of How to Use the PEG Ratio
The PEG ratio provides useful information to compare companies and see which stock might be the better choice for an investor's needs, as follows.
Assume the following data for two hypothetical companies, Company A and Company B:
- Price per share = $46
- EPS this year = $2.09
- EPS last year = $1.74
- Price per share = $80
- EPS this year = $2.67
- EPS last year = $1.78
Given this information, the following data can be calculated for each company.
- P/E ratio = $46 / $2.09 = 22
- Earnings growth rate = ($2.09 / $1.74) - 1 = 20%
- PEG ratio = 22 / 20 = 1.1
- P/E ratio = $80 / $2.67 = 30
- Earnings growth rate = ($2.67 / $1.78) - 1 = 50%
- PEG ratio = 30 / 50 = 0.6
Many investors may look at Company A and find it more attractive since it has a lower P/E ratio between the two companies. But compared to Company B, it doesn't have a high enough growth rate to justify its P/E. Company B is trading at a discount to its growth rate and investors purchasing it are paying less per unit of earnings growth.