What is the price / profit / growth ratio – PEG?
The price / earnings / growth ratio (PEG ratio) is the share price / earnings (P / E) ratio divided by the rate of earnings growth for a given period.
The PEG ratio is used to determine the value of a share while taking into account the expected growth in company profits and is believed to provide a more complete picture than the P / E ratio.
The price / earnings / growth ratio (PEG) formula is
Key points to remember
- The PEG ratio improves the P / E ratio by adding the expected profit growth to the calculation.
- The PEG ratio is considered an indicator of the real value of a share, and similar to the P / E ratio, a lower PEG may indicate that a share is undervalued.
- The PEG for a given business can differ considerably from one reported source to another, depending on the growth estimate used in the calculation, such as the projected growth over one or three years.
How to calculate the PEG ratio
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To calculate the PEG ratio, an investor or an analyst must find or calculate the P / E ratio of the company in question. The P / E ratio is calculated as the company’s share price divided by earnings per share (EPS), or the price per share / EPS.
Once the P / E has been calculated, find the expected growth rate for the stock in question, using the analyst estimates available on the financial websites that monitor the stock. Plug the numbers into the equation and solve the number of PEG ratios.
As with any report, the accuracy of the PEG report depends on the inputs used. When considering a company’s PEG ratio from a published source, it is important to know what growth rate was used in the calculation. Yahoo! Finance, for example, calculates the PEG using a P / E ratio based on data for the current year and an expected growth rate over five years.
Using historical growth rates, for example, can provide an inaccurate PEG ratio if future growth rates are expected to deviate from a company’s historical growth. The ratio can be calculated using growth rates expected over one year, three years or five years, for example.
To distinguish between calculation methods using future growth and historical growth, the terms “PEG before” and “Trailing PEG” are sometimes used.
What does the price / profit / growth ratio tell you?
While a low P / E ratio can make a stock look like a good buy, taking into account the company’s growth rate to get the PEG ratio of the stock can tell a different story. The lower the PEG ratio, the more the stock can be undervalued given its forecasts of future profits. Adding the expected growth of a company in the ratio allows adjusting the result for companies which may have a high growth rate and a high P / E ratio.
The extent to which a PEG ratio result indicates overvalued or undervalued stock varies by industry and by type of business. In general, some investors believe that a PEG ratio of less than one is desirable.
According to well-known investor Peter Lynch, a company’s P / E and expected growth should be equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company’s PEG exceeds 1.0, it is considered overvalued while a security with a PEG below 1.0 is considered undervalued.
Example of using the PEG ratio
The PEG ratio provides useful information for comparing companies and seeing which stock might be the best choice for an investor’s needs, as follows.
Suppose the following data for two hypothetical companies, company A and company B:
- Price per share = $ 46
- EPS this year = $ 2.09
- EPS last year = $ 1.74
- Price per share = $ 80
- EPS this year = $ 2.67
- EPS last year = $ 1.78
Based on this information, the following data can be calculated for each company.
- P / E ratio = $ 46 / $ 2.09 = 22
- Revenue growth rate = ($ 2.09 / $ 1.74) – 1 = 20%
- PEG ratio = 22/20 = 1.1
- P / E ratio = $ 80 / $ 2.67 = 30
- Revenue growth rate = ($ 2.67 / $ 1.78) – 1 = 50%
- PEG ratio = 30/50 = 0.6
Many investors can look at Company A and find it more attractive because it has a lower P / E ratio between the two companies. But compared to company B, it does not have a sufficiently high growth rate to justify its P / E. Company B is traded at a discount compared to its growth rate and the investors who buy it pay less per unit of earnings growth.