Price/Earnings-to-Growth Ratio (PEG Ratio)

What Is The PEG Ratio?

The PEG ratio is used by investors to compare a company’s price to earnings ratio to its expected earnings growth rate. In theory, the PEG ratio takes the PE ratio a step further by also accounting for growth. Investors calculating the PEG ratio use either forecasted growth rates or previous growth rates. The PEG ratio can be calculated using the ratio below.

PEG Ratio = (Market Price Per Share / EPS) / Expected(or Past) EPS Growth Rate

Where:

EPS = Earnings Per Share

Why Use The PEG Ratio?

A common complaint against the standard PE ratio is that in does not factor in growth. This leads to value traps for investors who believe a low PE must correlate with value. The PEG ratio attempts to solve this problem by comparing the PE ratio to the future EPS growth rate. In theory, a PEG ratio less than 1 indicates future growth which has not been priced into a stock and thus, creates a value opportunity. A PEG ratio much greater than 1, however, may indicate investors being overly optimistic and thus overvaluing a stock. This is due to the theory, popularized by legendary investor, Peter Lynch, who claimed that the EPS growth rate should be exactly reflected by the PE ratio. For example, a company which is expected to grow EPS at 13% should have a PE ratio of 13x.

Limitations To The Ratio

While in theory, the PEG ratio sounds great, it is not a perfect metric. As with anything that attempts to predict the future, the PEG ratio can mislead investors. Investors who rely on the PEG ratio too heavily assume that they can predict the future. The PEG ratio is only as accurate as the forecasted growth rate used. It is important to remember that even when using past growth rates, investors are still speculating and assuming that the past indicates the future. In order to maximize the effectiveness of the PEG ratio, investors must deploy thorough analysis in order to predict EPS growth as accurately as possible.

PEG Ratio Example

Let’s suppose that an investor is looking to find the PEG ratio for Company X. The investor goes through extensive analysis and concludes that Company X will likely grow EPS at 14% annually for the next few years. Because Company X is trading at 7x earnings, the investor calculates the PEG ratio as 0.5x. The investor concludes that the market is not factoring in Company X’s promising future and has undervalued its equity.

Investment Strategy

The PEG ratio is a useful metric that can help investors identify undervalued stocks with strong growth potential. The PEG ratio is calculated by dividing a company’s price-to-earnings (P/E) ratio by its expected earnings growth rate. A PEG ratio below 1 is considered attractive as it indicates that the stock may be undervalued relative to its growth potential.

Here’s an investment strategy that focuses on the PEG ratio:

1. Identify companies with a PEG ratio below 1: Start by screening for companies that have a PEG ratio below 1. This will help you identify stocks that are potentially undervalued relative to their growth prospects.
2. Evaluate the company’s financials: Once you have identified potential candidates, evaluate their financials to ensure that they have a healthy balance sheet, positive cash flow, and solid earnings growth potential. Look for companies with a history of consistent earnings growth and strong revenue growth prospects.
3. Consider the company’s industry and competition: Evaluate the company’s industry and competition to ensure that it has a sustainable competitive advantage that will allow it to continue to grow and outperform its peers.
4. Consider the broader market: Evaluate the broader market conditions and economic outlook to ensure that the company’s growth prospects are not being impacted by external factors such as a recession or industry disruption.
5. Monitor the company’s PEG ratio: Keep an eye on the company’s PEG ratio over time to ensure that it remains below 1. If the PEG ratio starts to rise above 1, it may be an indication that the stock is becoming overvalued relative to its growth prospects.
6. Diversify your portfolio: As with any investment strategy, it’s essential to diversify your portfolio to reduce risk. Consider investing in a range of companies with different PEG ratios and from different industries to spread your risk.

Overall, the PEG ratio can be a useful tool for investors looking to identify undervalued stocks with strong growth potential. By following these steps and doing your due diligence, you can potentially generate attractive returns from your investments.