Are you interested in investing in growth stocks but unsure how to value them? The Price/Earnings-to-Growth (PEG) ratio can help by including expected earnings growth in its valuation.
This article will explain how to use the PEG ratio to make smart investment decisions.
The Price/Earnings-to-Growth (PEG) ratio improves on the Price/Earnings (P/E) ratio by including a company’s earnings growth. This makes it a more useful tool for evaluating a stock’s value, helping to decide if a stock is under or overvalued based on its expected earnings growth.
The P/E ratio shows a stock’s current value compared to its earnings, but it doesn’t account for the company’s growth potential. The PEG ratio fixes this by dividing the P/E ratio by the annual earnings per share (EPS) growth rate, adding growth into the valuation.
To calculate the PEG ratio, you need two pieces of information:
The formula for the PEG ratio is:
PEG Ratio = ( Price / EPS ) / Earnings Growth
The PEG ratio is a useful metric for assessing how a stock is priced in relation to its earnings growth expectations.
A PEG ratio less than 1.0 might indicate that a stock’s price is low compared to its anticipated growth in earnings, suggesting it could be less expensive relative to its future earnings potential.
Conversely, a PEG ratio greater than 1.0 might suggest that a stock is priced high relative to its expected earnings growth, indicating it could be more expensive.
The inclusion of growth rate considerations makes the PEG ratio valuable for comparing companies across different industries, which may experience different growth rates.
This aspect of the PEG ratio helps provide a more nuanced view, enabling more grounded comparisons of company values in varying sectors.
To demonstrate the utility of the PEG ratio in stock evaluation, lets consider an example involving two fictional companies: TechGrow Inc. and StableCorp. Both companies are listed on the stock market, but they operate in different industry sectors and exhibit distinct growth patterns.
TechGrow Inc:
Calculated P/E ratio: $100 / $5.00 = 20
Earnings growth rate: ($5.00 / $4.00) – 1) = 25%.
PEG ratio: 20 / 25 = 0.8
StableCorp:
Calculated P/E ratio: $50 / $2.50 = 20.
Earnings growth rate: $2.50 / $2.40) – 1 = 4.17%.
PEG ratio: 20 / 4.17 = 4.8.
In this example, despite both companies having the same P/E ratio of 20, their PEG ratios differ significantly due to their growth rates.
TechGrow Inc. has a PEG ratio of 0.8, which suggests its stock might be undervalued based on its growth potential, making it a more appealing investment.
In contrast, StableCorp has a PEG ratio of 4.8, indicating its stock is overvalued given its slower earnings growth, making it less attractive.
This example shows how the PEG ratio can be an important tool in comparing stocks across different industries and with varying growth rates, providing a clearer picture of potential investment value relative to future earnings growth.
While the P/E ratio is a common tool for assessing stock value, the PEG ratio offers a more comprehensive evaluation by including future earnings growth. This added dimension helps paint a more detailed picture of a company’s market value relative to its projected earnings.
However, the accuracy of the PEG ratio heavily depends on the quality of the earnings growth forecasts used. Inaccurate predictions or the inappropriate extension of past growth trends into the future can lead to misleading PEG ratios, making it crucial to use reliable and thoughtful estimates.
A PEG below 1 is considered good; it means that a stock could be undervalued with respect to the earnings growth expected.
Whereas a low PEG ratio might point out undervaluation, one has to look at the industry’s prospects, market conditions, and the company’s overall financial stability.
The PEG ratio does well for any company with a high growth potential. A stock in a slow-growth industry or one about to begin paying high dividends will not be so useful when evaluated using the PEG ratio.
The PEG ratio should be recalculated anytime new earnings reports are announced and when there is a change in growth forecasts by analysts.
