PEG ratio is often used to bridge the gap between value and growth.
Most value investors tend to consider the P/E ratio as one of the more important qualifying metric to find a value stock. However, the P/E ratio often does not tell the complete story. A stock may sell for a low price to earnings multiple and appear to be undervalued, but it is not necessarily an good investment. For example, if the company expects earnings declines in the future, the low P/E ratio may actually mask the overvaluation in the stock price.
What is PEG Ratio?
PEG ratio or Price/Earnings-Growth ratio is an attempt to normalize the P/E ratio with the expected earnings growth rate of the company.
The idea behind the PEG ratio for stocks is quite simple:
A low P/E ratio can be justified if the future expected earnings growth is low. A fast growing company on the other hand is able to command a higher price to earnings multiple for its stock. To get more accurate idea of the relative valuation of a company, we need to consider the P/E ratio in conjunction with the future earnings per share growth rate.
How is PEG Ratio Calculated?
You can calculate the PEG ratio using a 2 step process.
Step 1: Calculate the P/E Ratio
P/E ratio is generally calculated as the Stock Price / Earnings per Share. This can also be expressed as Market Capitalization / Net Income.
Step 2: Calculate the PEG Ratio
Next, we divide the P/E ratio calculated above with the expected Earnings growth rate.
PEG ratio = P/E ratio / Earnings Growth Rate
PEG Ratio Example
Suppose we are comparing 2 different stocks with the following characteristics
Stock XYZ: Price = $10/share, Earnings = $2/share, Expected EPS growth = 5%
Stock ABC: Price = $20/share, Earnings = $2/share, Expected EPS growth = 20%
For stock XYZ,
P/E ratio = $10/$2 = 5
PEG ratio = 5/5 = 1
For stock ABC
P/E ratio = $20/$2 = 10
PEG ratio = 10/20 = 0.5
In the example above, if the investor only considers the P/E ratio for valuation purposes, he will determine that the stock XYZ is a better value since it has a P/E ratio that is 50% less than that of stock ABC.
Once you consider that the company ABC is expected to grow its earnings 4 times faster than the company XYZ, you may now change your mind. Using price to earnings growth you find that the stock ABC trades at a lower PEG ratio than stock XYZ and therefore may offer a much better value.
Check out these recommended investment advice websites
What is a Good PEG Ratio?
Typically, it is recommended to target a PEG ratio of 1 or below when you are looking for a good value stock.
However, there are multiple issues with this recommendation:
1. Earnings growth expectations are completely unreliable. Any use of the formula is only as good as the numbers that are fed into it as inputs. Any expected earnings growth in the future is just an expectation, and they vary wildly between different analysts. Even if there is a consensus, the future generally turns out to be different than planned. There is competitive changes, loss of market power, product substitutions, management missteps, etc, that we have no way of knowing today.
Read more: what is price to book value
2. Typically P/E ratios are backward looking while the earnings growth rate is a forward looking metric. Future P/E ratio will be different than the one we use today. You could project a future P/E ratio if you wish, but this will introduce further uncertainty in the calculations. Still, many investors are fond of using the concept of Forward P/E and Forward PEG ratio. I strongly advise against this.
3. There are industry specific differences in the natural P/E ratios and growth rates
Instead, I recommend that you consider the relative PEG ratios between different stocks within an industry and lean towards picking the stocks with lowest PEG ratios.
A large amount of error in the future earnings growth arises from an overly optimistic or pessimistic outlook for the industry as a whole. Very likley an analyst will introduce similar error shifts in all the stocks within a given industry. So while the individual PEG ratios will be wrong, on a relative basis you may still come out with a good value stock. This assumes that you have settled on the industry as an attractive investment possibility (perhaps a cyclical opportunity – what are cyclical stocks?).
What does a High PEG Ratio Mean?
A high PEG ratio means either the P/E Ratio is very high, or the Growth rate is very low. Either way the stock is likely to be very expensive in valuation. There are cases when a high P/E ratio can result from a temporary decline in earnings, which will likely recover shortly. These situations tend to be overlooked by most investors so it is important to follow up if you suspect this is the case.
Another possibility is that the market expects the growth rate to slow down significantly in the near term. However, if you believe that the market is incorrect in its judgement, you should take a closer look at the high PEG stock. I expect these situations to be very rare as the market will also beat down the P/E ratio in such cases.
Is a Negative PEG Ratio Good?
Sometimes you will run across a negative PEG ratio value. This could mean one of the two things:
1. The company lost money in the prior period (earnings were negative so it has a negative pe ratio), or,
2. The company is profitable but the profitability is expected to decline in the future (earnings growth rate is negative) [See: how to calculate profit]
A negative PEG ratio does not imply that the stock is a bad investment. It just means that you need to consider other ways of looking at the stock before you can judge if this is a good investment or not.
Relationship between Earnings, Price, Growth Rate, Dividend and PEG of a Company
All things being equal, a lower earnings will increase PEG as it is a denominator in calculating PEG. However, the price rarely stays equal, unless the decline in earnings is considered to be temporary. Similarly, if the growth rate goes down, the PEG will go up as well, and vice versa. Since Price is the numerator, any increase in price that is not justified by higher earnings or higher growth rate will increase PEG and such stocks should be avoided. A decline in price with other things being equal will reduce PEG and we may be looking at a value stock at some point.
What does a dividend have anything to do with PEG? If you recall that the price of stock gets adjusted down when a dividend is paid, you can see why a dividend paying stock may seem to have lower PEG ratio than a non-dividend paying stock. However, this effect is generally inconsequential when it comes to valuing a stock, but certainly something to keep in mind. Additionally, paying dividends will reduce the growth rate of the company going forward as there is less capital to reinvest.
I suggest that any stock can be a good investment at a price that is cheap enough. The idea behind PEG ratio, or any other valuation metric, is to judge the valuation before you buy stocks. While these metrics bring some sort of formulaic structure to the investment process, investing well is much more than using a set of formulas. We have collected a list of key financial ratios every investor should consult.
View other Key Financial Ratios here