PEG Ratio: Definition & Formula

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Price / Earnings-To-Growth Ratio Meaning

The Price / Earnings-To-Growth (PEG) ratio is a financial metric that helps investors better understand stocks they’re considering investing in. Many investors look at a company’s price-to-earnings ratio (P / E ratio) to determine if that company is a good investment but a company’s P / E ratio might be hiding the fact that the stock is overpriced or underpriced without future earnings growth is taken into account.

A company’s price-to-earnings ratio is simply the price of its stock divided by the company’s earnings per share. However, if two companies have the same price-to-earnings ratio but one company has experienced a 40% growth in earnings over the last three years while the other only experienced a 10% growth in earnings, the stock that is growing faster is likely underpriced and could be the better company to invest in.

By dividing the stock’s P / E ratio by the company’s growth rate, an investor can better understand whether a company’s P / E ratio will change in the future, creating a situation where the stock price either provides greater value or the stock price goes up.

Tip: A stock with a low PEG ratio might not always be a better choice. High-growth companies are more likely to be volatile and have inconsistent earnings.

PEG vs. P / E Ratio

The P / E ratio of a company is calculated by taking a stock’s price per share and dividing it by its annual earnings per share. This is done to determine what the ratio is between a company’s annual earnings and its stock price. For example, if a stock earns $ 5 per share and has a stock price of $ 20 per share then the company’s P / E ratio is 4. That means that its share price is 4x its earnings.

A PEG ratio is calculated by taking that P / E ratio and then dividing it by a company’s growth rate over a specific period of time. For example, if the stock mentioned above grew 20% in the last year, its PEG ratio would be 0.2.

Both metrics tell investors something about a company, but the PEG ratio includes data that the P / E ratio leaves out, helping give an investor a better idea of ​​a company’s value in relation to its share price.

Tip: There are online calculators that help determine the PEG ratio of a company.

Calculating Using The PEG Ratio Formula

The formula for calculating the PEG ratio is simple. Just divide the price / earnings ratio by the earnings per share growth rate.

Price Earnings Growth Ratio (PEG) = Price Earnings Ratio (P / E) / Earnings per Share Growth Rate

This is a PEG Ratio equation.  It says PEG Ratio = P / E Ratio / Earnings Growth Rate

PEG Ratio Equation (Seeking Alpha)

Price / Earnings Growth Examples

Here is an example of how comparing the PEG ratio of two companies can be useful in understanding the company’s value better.

There are two companies that sell cars. Acme Cars has a share price of $ 100 and earnings per share of $ 10 and earnings per share last year of $ 9. Beta Cars has a share price of $ 50 and earnings per share of $ 2 and earnings per share last year of just $ 1.25.

Acme Cars

Price per share = $ 100

Earnings per share this year = $ 10

Earnings per share last year = $ 9

Beta Cars

Price per share = $ 50

Earnings per share this year = $ 2

Earnings per share last year = $ 1.25

Acme Cars PEG Ratio

P / E ratio = $ 100 / $ 10 = 10

Earnings per share growth rate = ($ 10 / $ 9) – 1 = 11%

PEG ratio = 10/11 = 0.9

Beta Cars PEG Ratio

P / E ratio = $ 50 / $ 2 = 25

Earnings per share growth rate = ($ 2.00 / $ 1.25) – 1 = 60%

PEG ratio = 25/60 = 0.41

Takeaway: While many investors might have believed Acme Cars was the better automobile investment because it had a lower P / E ratio than its competitor, Beta Cars’ growth rate is significantly higher. Therefore, Beta Cars is more undervalued and could be a better investment since investors have a higher likelihood of experiencing more earnings growth for every dollar invested in Beta Cars.

PEG Ratio Interpretation For Investors

PEG ratios can be used to better understand whether a company is appropriately priced, underpriced, or overpriced relative to its future earnings. Calculating a stock’s PEG ratio can also be helpful in order to compare it to other companies in the same industry.

While many investors use the P / E ratio to compare the relative performance of a stock to its competitors, this is a problematic metric to use if two companies are at different stages of their lifecycle or one is growing much more quickly. The PEG ratio takes companies’ different growth rates into account so that investors can better understand a stock’s price relative to its potential for future growth. This helps investors find stocks that are likely to increase in value in the future.

Tip: Some investors believe that a company that has a PEG ratio of 1 means a company is fairly priced since that means that the company’s P / E ratio and their expected growth are equal. If a company has a PEG ratio of higher than 1, many investors believe that means that the stock is overvalued since its future growth does not justify its stock price. If a company has a PEG ratio of less than 1, many investors consider that company as undervalued since, if that growth rate continues, its earnings will be higher the following year shifting the P / E and PEG ratios, unless its stock price continues to increase as well.

Benefits & Limitations of the PEG Ratio

Pros of PEG

  • Allows investors to better compare stocks: PEG ratios help investors compare stocks that are growing at different rates.
  • Low PEG ratios can indicate future price movement: This can potentially indicate a higher stock price in the future since the security’s growth has not yet been priced into its share price.
  • Dividend growth: Companies with low PEG ratios are often more likely to grow their dividends in the future.
  • More meaningful than P / E ratio: A PEG ratio gives you a better understanding of a company’s potential future value.

Pitfalls & Limitations

  • Earnings might not continue to grow at the same rate: The PEG ratio assumes that earnings growth will remain constant.
  • Growing companies can be more volatile: Companies that are growing rapidly are more likely to miss earnings or stumble than established companies that grow at a slower rate.
  • Does not replace a deeper analysis: Investors should still do a comprehensive analysis of a company’s financial statements, leadership, and projections.

Bottom Line

A PEG ratio is a useful metric investors can leverage to better understand a company’s value. It is particularly useful in comparing growing companies with established companies to understand their stock prices’ relative value.

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