PEG Ratio (Price/Earnings-to-Growth) Definition & Calculation

KEY TAKEAWAYS

• The PEG ratio is an effective indicator of the true value of a specific stock. It can help show insights into whether or not a stock is undervalued or not.
• The calculations for the PEG ratio can vary from a one-year or three-year projected growth, for example. This means that the PEG ratio for one company might differ from another depending on the growth estimate used.
• The PEG ratio takes the P/E ratio one step further by including and calculating expected earnings growth

What Is Price/Earnings-to-Growth, or PEG Ratio?

The PEG ratio is a financial metric that gets used to help determine a stock’s value. It also takes into account the expected earnings growth of a company, and some of this information is found on financial statements. By doing it this way, it helps provide a complete picture compared to the standard price to earnings ratio.

The P/E ratio is often the most common metric that gets used when valuing a potential stock. Yet, this type of ratio isn’t always the most useful when it gets used on its own. This is since it’s not going to take into account a company’s future earnings growth rate. 

Since the PEG ratio does consider a company’s growth rate period, it allows for a better representation of a growing company’s valuation and can show the potential for growth. In most cases, having a PEG ratio that’s less than 1 could indicate a stock is undervalued. On the flip side, a PEG ratio that’s more than 1 might indicate a stock is far too expensive. 

That said, using the PEG ratio is only a small part of conducting a thorough valuation. And depending on your industry, there might be different average PEG ratios to consider. An investment portfolio might have varying plans for growth stocks. 

If company A has a different share growth rate or rate of growth compared to company B, they’re going to have a different earnings to growth ratio. 

How to Calculate the PEG Ratio 

The good news is that calculating the PEG ratio is relatively simple to do. The first thing an analyst or investor will do is calculate the P/E ratio. This gets done by calculating the price per share of a company and then dividing it by the earnings per share (EPS). It would look like this:

Once the P/E ratio is able to get calculated, it’s now time to find the expected growth rate for the stock. Analyst estimates that are available on financial websites allow the investor or analyst to follow the stock and find the data needed. Then, these figures can get plugged into the equation to calculate the PEG ratio. 

The formula for calculating the PEG ratio would look like this: 

Benefits & Limitations of the PEG Ratio

The PEG ratio can bring several benefits, but it can also have a few limitations that are worth understanding. Let’s take a closer look.

Benefits of the PEG ratio include:

• Opportunities to compare stocks: Investors are able to gain insights into the growth rates of various stocks and compare them together. 
• Dividend growth: A company that has a lower PEG ratio has a higher likelihood of being able to grow future dividends. 
• Indicates future movement: A low PEG ratio could indicate a stock price could be higher in the future. This is since the share price hasn’t included potential security growth.
• It provides more value: Compared to the P/E ratio, the PEG ratio can provide more meaningful details about the potential future value of a company.

Limitations of the PEG ratio include: 

• Earnings aren’t always constant: The PEG ratio doesn’t necessarily mean that earnings will grow consistently, it only assumes that growth could be constant.
• It doesn’t replace other types of analysis: It’s always important for investors to conduct other types of analysis when looking into the projections, leadership, and financial statements of a company. 
• It could show potential volatility: Growing companies have the possibility of missing earnings compared to a company that’s growing at a slower rate. 

What Does the PEG Ratio Tell You About a Stock?

Typically, having a lower P/E ratio can indicate that a stock would be a good purchase. Yet, when you factor in the company’s growth rate it can tell a different story. When the PEG ratio is lower, it likely indicates that the stock is undervalued. You’re able to generate these insights by the stocks’ future earnings expectations and earnings forecasts.

So in this case, being able to add the expected growth rate into the ratio will adjust the results to become a little more accurate. This is beneficial for companies that might have a high P/E ratio and also a high growth rate.

It’s important to recognize that the PEG ratio is going to vary from industry to industry. The specific type of company will also affect the results when it comes to whether a stock is over or underpriced. That said, it’s fairly common for investors to see a PEG ratio that’s less than 1 as being most desirable.

Summary

The PEG ratio is an effective way to determine the value of a specific stock and potential growth. Since the P/E ratio doesn’t take into account a company’s growth rate. The PEG ratio helps provide a clearer picture. This allows for a growing company to have a better representation of its valuation.

Depending on the industry, the PEG ratio can be a little different. However, in most cases, a PEG ratio that’s under one can indicate an undervalued stock. Whereas a PEG ratio that’s above 1 can indicate a stock is too expensive. Essentially, the PEG ratio is an effective way to calculate a growth forecast and see differences in growth rates.

Faster growth rates might indicate good investment criteria and a range of investment options. Knowing how to calculate the PEG ratio can help with both current investments and future investment goals. You’ll be able to make more informed decisions between an attractive investment and a bad investment.