Valuation ratios are important for investors and financial experts to determine if a public company is worth the value they are presenting to investors. One of the valuation ratios you can use to help assess a company stock is the price/earnings-to-growth (PEG) ratio.
This valuation is an extended version of the price-to-earnings ratio (P/E), a common way that investors measure the valuation of two different stocks. The PEG ratio takes the comparison a step further by including a variable of growth.
Overall, this ratio gives investors more information on a stocks value and potential for earning.
How Do PEG Ratios Work?
The PEG ratio provides a stock’s P/E ratio that is then divided by the growth rate of its earnings over a one-year or five-year period. It provides a clear picture when determining the stock’s current value while taking into consideration the expected growth earnings of that company.
PEG ratios are very popular with investors because the formula helps relate the P/E value to a vital piece of information – the company’s growth rate. The reason this is so valuable is because assessing growth can provide you insight on how high of a return to expect.
How To Calculate the PEG Ratio
You will need to utilize the following formula to calculate the PEG ratio:
PEG = (Share Price / Earnings Per Share) / Earning Per Share Growth Rate
What Is an Example of a PEG Ratio?
Now that we have the formula to calculate the PEG ratio, let’s examine two hypothetical companies, Company X and Company Y, to compare and assess their PEG ratios:
·Price per share = $58
·EPS this year = $2.50
·EPS last year = $2.00
·Price per share = $145
·EPS this year = $14.50
·EPS last year = $10.00
Based off of this information we can use the above formula to calculate the following:
·P/E Ratio = $58 / $2.50 = 23.20
·Earning growth rate = ($2.50 / $2.00) – 1 = -50%
·PEG Ratio = 23.20 / -50 = -0.464
·P/E Ratio = $145 / $14.50 = 10
·Earning growth rate = ($14.50 / $10.00) – 1 = 45%
· PEG Ratio = 10 / 45 = 0.222
What Are Good PEG Ratios?
Typically, if a PEG ratio is 1.0 or lower, the stock is priced fairly or could even be undervalued. If the ratio is above 1.0, it is likely that the stock is overvalued. A PEG ratio can also be represented as a negative number.
Both PEG ratios in the above scenario are less than 1 indicating they are potentially good buys.
Is a Negative PEG Ratio Good?
If the stock you are calculating has a negative PEG ratio, it means that the company is losing money (the P/E ratio is negative), or that the company earnings are anticipated to decrease in the future (estimate growth rate for the future is negative).
However, it is important to remember that even the strongest of companies can see a negative growth in their earnings due to financial hardships or economic downturns, so it is important to consider the earnings overtime.
If you find a company with a negative PEG ratio, take a deeper dive into the growth of the company and assess outside influencing factors before writing that stock completely off.
How Are PEG Ratios Used to Compare Companies?
When investors are determining which stocks to add to their portfolio (or remove), the PEG ratio provides helpful information that allows them to make an educated choice. When using this strategy to help guide investment decisions, it is always best to compare apples to apples, meaning compare similar stocks within the same industry.
Cross-sector stocks will not provide you with an appropriate picture of what to expect within each industry.
How Do PEG Ratios Affect Stocks?
This valuable metric is key for investors to assess the trade-off between the current price of a stock with the earnings per share, while factoring in the expected growth for the company. The biggest disadvantage to using PEG ratios when assessing stocks is that it is not an appropriate way to measure companies that do not have high growth.
Companies that are large and established can offer dependable dividends but have limited growth opportunities. It is important to review other metrics as well before selecting a stock.
Where Can I Find PEG Ratios for Stocks?
To find the PEG ratio for stocks you will need three things:
·Earnings per share
·Expected rate of growth
To determine the price of a stock, use the current market price. You can then find historical data that shows the current year’s earnings per share and the previous earnings per share data for the past year or five years.
After you have those pieces, you can calculate the expected rate of growth to determine the PEG ratio.
How Do You Interpret PEG Ratios?
Based on the examples above, you can tell that Company X had a higher P/E ratio at 23.2, versus Company Y whose ratio was only 10. But a major difference between the two companies is the growth.
While Company X did have a higher P/E ratio, Company X had a much lower PEG ratio than Company Y. This is due to the difference in both companies’ growth rates.
When analyzing PEG ratios, it’s crucial to look deeper at the calculations to fully interpret what the ratio is saying. Looking at our example, you see that a company with a higher P/E does not always mean a higher growth rate.
It is important to review all pieces of information before making an educated decision.
Why Are PEG Ratios Meaningful?
PEG ratios can be an important measurement of a company’s value by providing investors with insight into whether a stock is currently under or overpriced. Not only does the PEG help to calculate the relative value of a stock, it also provides one with insights on that firm’s future growth in earnings.
Overall the PEG ratio provides several insights that help investors determine whether or not they want to purchase a certain security.
Consider Other Factors Outside of PEG Ratio
PEG ratios are a meaningful tool to help you determine if stocks from various companies are worth the investment. It allows you to compare stocks to see which company is the best fit for your portfolio, but it is not the only tool you should utilize.
Understanding other factors like price-to-earning and price-to-book ratios will also help you analyze and evaluate stocks. If you need guidance on how to utilize PEG ratios for your portfolio, find a financial advisor.
Financial advisors can support your future goals by helping you understand PEG ratios and other important calculations to consider when adding securities to your portfolio.