Price earning to growth (PEG) ratio

What does it mean?

The PEG ratio (Price/Earnings to Growth ratio) is one of the most popular valuation ratio calculated for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth

• P/E ratio from which the PEG is derived is generally higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies overvalued relative to others

• It is assumed that by dividing the P/E ratio by the earnings growth rate, the

resulting ratio is better for comparing companies with different growth rates

• It was popularized by Peter Lynch, who wrote The P/E ratio of any company that's fairly priced will equal its growth rate", i.e. a fairly valued company will have its peg equal to 1

What does it mean?

PEG = (P/E) / (projected growth in earnings)

For example : A stock with a P/E of 30 and projected earnings growth next year of 15% would have a PEG of 30 / 15 = 2.

A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive).

It should be noted that the P/E ratio used in the calculation may be projected or trailing, and the annual growth rate may be the expected growth rate for the next year or the next five years.

Basic formula

What does PEG indicate?

• PEG is a popular indicator of a stock's correct value. Similar to PE ratios, a lower PEG means that the stock is undervalued more

• It is favored by many over the price/earnings ratio because it also accounts for growth. If a company is growing at 30% a year, then the stock's P/E could be 30 to have a PEG of 1. The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth

• A crude analysis suggests that companies with PEG values between 0 to1 may provide higher returns

• The PEG ratio, despite its wide use, is only a rule of thumb and has no accepted underlying mathematical basis

Advantages

• Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company

• The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company

Disadvantages

• The PEG ratio is less reliable for measuring companies with low growth rates. Large, well-established companies for instance may offer dependable dividend income but little opportunity for growth

• A low (attractive) PEG in times of high growth in the entire economy may not be particularly impressive when compared to other stocks and vice versa for high PEG's in periods of slow growth or recession

• In addition, company's growth rate is much higher than the economy's growth rate is unstable and vulnerable to any problems the company may face that would prevent it from keeping its current rate

• PEG also has no implicit or explicit correction for inflation (i.e., a company with growth equal to the rate of inflation is not growing in real terms)

CONCLUSION

Thus we can say that though there are certain advantages of using the PEG ratio like it accounts for growth and easy to calculate it has certain disadvantages also and it can also be an misleading indicator at times thus it should be used with utmost care and only in those situations where it shows the right picture

Thank You!

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