What is the Price/Earnings-to-Growth (PEG) Ratio?

What is PEG Ratio?
The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while also factoring in the company’s expected earnings growth and is thought to provide a more complete picture than the more standard P/E ratio. The formula is:

PEG Ratio = (Price / EPS ) / EPS Growth  

EPS = Earnings Per Share

To interpret the ratio, a result of 1 or lower says the stock is either at par or undervalued based on its growth rate. If the ratio results in a number above 1, it is interpreted that the stock is overvalued relative to its growth rate. The degree to which a PEG ratio result indicates an over or undervalued stock varies also by industry and company type. As a broad rule of thumb, some investors feel that a PEG ratio below one is desirable.

As with any ratio, the accuracy of the PEG ratio depends on the inputs used. When considering a company's PEG ratio from a published source, it's important to find out which growth rate was used in the calculation. Using historical growth rates, for example, may 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 one-year, three-year, or five-year expected growth rates, for example.

Price to Earnings (P/E) Ratio vs PEG Ratio
The price to earnings (P/E) ratio is one of the simplest tools that is used to evaluate the stock of a company.  It involves taking a company’s current stock price and dividing it by the earnings per share (EPS). It shows whether a company’s stock is overvalued or undervalued. In addition, it also reveals how a stock's valuation compares to its industry group or a benchmark. The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings.

Typically, the stocks with high P/E are considered overvalued, whereas those with low P/E are regarded as undervalued. Nevertheless, it is not always the case. Any P/E ratio needs to be considered against the backdrop of the P/E for the company's industry.

However, P/E ratio does not factor in the company’s future growth rate which may result in erroneous conclusions while valuing a stock. Various companies grow at different rates in their life cycles. During the establishment phase, growth rates tend to be high compared with those in the maturity phase. If investors go only by the P/E ratio, the companies that grow slowly would seem attractive as their stocks would be trading at substantially lower P/E multiples. The high-growth companies, on the other hand, would appear expensive as they would trade at higher P/E multiples.

This makes PEG ratio a more suitable tool for valuation. It provides more insight into a stock’s valuation by providing a forward-looking perspective. Although PEG ratio has its own limitations where it is not applicable to real estate and airlines as these are valued on the basis of asset values, it is one of the major ratios used for valuation due to its futuristic approach and broader scope.

However, no single ratio can tell investors all they need to know about a stock. It is important to use a variety of ratios to arrive at a complete picture of a company's financial health and its stock valuation.

Key Takeaways

• The PEG ratio is instrumental in determining a stock's value while also factoring in the company’s expected earnings growth
• It can be calculated by dividing a stock’s P/E ratio by its EPS growth
• If the ratio is <=1, the stock is either at par or undervalued based on its growth rate. If the ratio is >1, the stock is overvalued relative to its growth rate
• P/E ratio does not factor in the company’s future growth rate which may result in erroneous conclusions while valuing a stock. Therefore, PEG ratio helps defeat this disadvantage of P/E ratio
• However, PEG ratio is not applicable to real estate and airlines as these are valued on the basis of asset values
• But PEG ratio helps give a forward-looking perspective to a stock’s valuation

This material is part of an Investor Education and Awareness Initiative of Canara Robeco Mutual Fund