PEG ratio
The PEG ratio is a valuation metric for determining the relative tradeoff
between the price of a stock, the earnings generated per share (EPS), and
the company's expected future growth. It is a ratio used to determine a
stock's value while taking into account earnings growth.
The calculation is as follows:
PEG ratio =(Price/Earnings ratio)/
Annual EPS growth
Let's look at two hypothetical stocks to see how the PEG ratio is
calculated:
ABC Industries has a P/E of 20 times earnings. The consensus of all the
analysts covering the stock is that ABC has an anticipated earnings growth
of 12% over the next five years.
20 (x times earnings) / 12 (n % anticipated
earnings growth) = 20/12 = 1.66
XYZ Micro is a young company with a P/E of 30 times earnings. Analysts
conclude that the company has an anticipated earnings growth of 40% over
the next five years.
30 (x times earnings) / 40 (n % anticipated
earnings growth) = 30/40 = 0.75
Using the examples above, the PEG ratio tells us that ABC Industries stock
price is higher than its earnings growth. This means that if the company
doesn't grow at a faster rate, the stock price will decrease. XYZ Micro's
PEG ratio of 0.75 tells us that the company's stock is undervalued, which
means it's trading in line with the growth rate and the stock price will
increase.
It is generally accepted that a PEG ratio of 1 represents a reasonable
tradeoff between cost (as expressed by the P/E ratio) and growth. This
would represent theoretical equilibrium between the market value of a
stock and anticipated earnings growth. For example, a stock with an
earnings multiple of 20 and 20% anticipated earnings growth would have a
PEG ratio of 1.
PEG ratio results greater than 1 suggest one
of the following:
The market's expectation of growth is higher than consensus estimates.
The stock is currently overvalued due to heightened demand for shares.
PEG ratio results of less than 1 suggest one of the following:
Markets are underestimating growth and the stock
is undervalued.
Analysts' consensus estimates are currently set
too low.
In general, the P/E ratio is higher for a company with a higher growth
rate. Thus using just the P/E ratio would make highgrowth companies
overvalued relative to others. A lower ratio is "better" (cheaper) and a
higher ratio is "worse" (expensive). A PEG ratio that gets close to 2 or
higher is generally believed to be expensive, that is, the price paid
appears to be too high relative to the estimated future growth in
earnings.
Advantages
PEG is a widely used indicator of a stock's potential value. It is favored
by many over the price/earnings ratio because it also accounts for
growth.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.
A great feature of the PEG ratio is that by bringing future growth
expectations into the mix, we can compare the relative valuations of
different industries that may have very different prevailing P/E ratios.
This makes it easier to compare different industries, which tend to each
have their own historical P/E ranges. For example, let's compare the
relative valuation of a biotech stock to an integrated oil company:
Biotech Stock ABC
Current P/E: 35 times earnings
Fiveyear projected growth rate: 25%
PEG: 35/25, or 1.40 Oil Stock XYZ
Current P/E: 16 times earnings
Fiveyear projected growth rate: 15%
PEG: 16/15, or 1.07
Even though these two fictional companies have very different valuations
and growth rates, the PEG ratio allows us to make an applestoapples
comparison of their relative valuations. What is meant by relative
valuation? It is a mathematical way of asking whether a specific stock or
a broad industry is more or less expensive than a broad market index, such
as the S&P 500 or the Nasdaq.
So, if the S&P 500 has a current P/E ratio of 16 times trailing earnings
and the average analyst estimate for future earnings growth in the S&P 500
is 12% over the next five years, the PEG ratio of the S&P 500 would be
(16/12), or 1.25.
Disadvantages
1. The PEG ratio is less appropriate for measuring companies without high
growth. Large, wellestablished companies, for instance, may offer
dependable dividend income, but little opportunity for growth.
The PEG ratio is best suited to stocks with little or no dividend yield.
Because the PEG ratio doesn't incorporate income received by the investor
in its presentation of valuation, the metric may give unfairly inaccurate
results for a stock that pays a high dividend.
Consider the scenario of an energy utility that has little potential for
earnings growth. Analyst estimates may be 5% growth at best, but there is
solid cash flow coming from years of consistent revenue. The company is
now mainly in the business of returning cash to shareholders. The dividend
yield is 5%. If the company has a P/E ratio of 12, the low growth
forecasts would put the PEG ratio of the stock at 12/5, or 2.50. An
investor taking just a cursory glance could easily conclude that this is
an overvalued stock. The high yield and low P/E make for an attractive
stock to a conservative investor focused on generating income. Be sure to
incorporate dividend yields into your overall analysis. One trick is to
modify the PEG ratio by adding the dividend yield to the estimated growth
rate during calculations. To give us a meaningful interpretation of the
company's valuation, take a look a look at the following example.
Example  Adding Dividend Yield to the Estimated Growth Rate
This energy utility has an estimated growth rate of about 5%, a 5%
dividend yield and a P/E ratio of 12. In order to take the dividend yield
into account, you could calculate the PEG like this:
P/E / (Growth Estimates + Yield) = (12 /
(5 +5)) = 1.2
2. A company's growth rate is an estimate. It is subject to the
limitations of projecting future events. Future growth of a company can
change due to any number of factors: market conditions, expansion
setbacks, and hype of investors.
The convention that (PEG=1) is appropriate is somewhat arbitrary and
considered a rule of thumb metric. Mathematically, growth faster than
growth of the economy cannot be infinite (or the company would eventually
become larger than the economy), and the PEG ratio does not correct for
the period of time that fasterthannormal growth will continue. In
addition, there is 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). Hence, the PEG ratio lacks a coherent conceptual framework,
and is used solely as a somewhat inquisitive metric of the extent of the
growth/price tradeoff.
At extremes, and particularly for lowgrowth companies, the PEG ratio
implies valuations that may appear to be nonsensical. For example, the PEG
ratio "rule of thumb" implies that a company with 1% growth in earnings
per annum should have a P/E ratio between 1 and 2, a level that would
appear to be extremely low. For companies with zero expected growth, the
ratio is undefined (division by zero), and for companies with negative
growth, the result (a negative PEG ratio, for example) may be meaningless.
Final Thoughts on Using the PEG
Thorough and thoughtful stock research should involve a solid
understanding of the business operations and financials of the underlying
company. This includes knowing what factors the analysts are using to come
up with their growth rate estimates, and what risks exist regarding future
growth and the company's own forecasts for longterm shareholder returns.
Investors must always keep in mind that the market can, in the shortterm,
be anything but rational and efficient. While in the long run stocks may
be constantly heading toward their natural PEGs of 1, shortterm fears or
greed in the markets may put fundamental concerns on the backburner.
When used consistently and uniformly, the PEG ratio is an essential tool
that adds dimension to the P/E ratio, allows comparisons across diverse
industries and is always on the lookout for value.
