What is the Price/Earnings To Growth - PEG Ratio
The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio.
BREAKING DOWN Price/Earnings To Growth - PEG Ratio
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 can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The degree to which a PEG ratio value indicates an over or underpriced stock varies by industry and by company type, though a broad rule of thumb is that a PEG ratio below one is desirable. Also, the accuracy of the PEG ratio depends on the inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. To distinguish between calculation methods using future growth and historical growth, the terms "forward PEG" and "trailing PEG" are sometimes used.
PEG Ratio Calculation Examples
To calculate the PEG ratio, and investor or analyst needs to first 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):
P/E ratio = Price per share / EPS
Once the P/E is calculated, the PEG ratio's formula is simply:
PEG ratio = P/E ratio / earnings growth rate
Assume the following data for two hypothetical companies, Company A and Company B:
Company A price per share = $46
Company A EPS this year = $2.09
Company A EPS last year = $1.74
Company B price per share = $80
Company B EPS this year = $2.67
Company B EPS last year = $1.78
Given this information, the following data can be calculated for each company:
Company A P/E ratio = $46 / $2.09 = 22
Company A earnings growth rate = ($2.09 / $1.74) - 1 = 20%
Company A PEG ratio = 22 / 20 = 1.1
Company B P/E ratio = $80 / $2.67 = 30
Company B earnings growth rate = ($2.67 / $1.78) - 1 = 50%
Company B PEG ratio = 30 / 50 = 0.6
Many investors may look at Company A and find it more attractive since it has the lower P/E 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.