The PEG ratio is calculated easily and represents the ratio of the P/E to the expected future earnings growth rate of the company. This article will discuss the positive attributes of the metric, how to best use it in your research and what to watch out for when using it.
Determining a Stock's Value
Common stocks represent a claim to future earnings. The rate at which a company will grow its earnings going forward is one of the largest factors in determining a stock's intrinsic value. That future growth rate represents everyday market prices in stock markets around the world.
The P/E ratio shows us how much shares are worth compared to past earnings. Most will use 12-month trailing earnings to calculate the bottom part of the P/E ratio. Inferences may be made by looking at the P/E ratio; for instance, high P/E ratios represent growth stocks, while low ones highlight value oriented stocks. (For more insight, read Understanding The P/E Ratio.)
Example - Calculating the PEG
Let\'s look at two hypothetical stocks to see how the PEG ratio is calculated:
ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years.
20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66
XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years.
30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75
What the PEG Ratio Tells Us
Using the examples above, the PEG ratio tells us that ABC Industries stock price is higher than its earnings growth. This means that if the company doesn't grow at a faster rate, the stock price will decrease. XYZ Micro's PEG ratio of 0.75 tells us that the company's stock is undervalued, which means it's trading in line with the growth rate and the stock price will increase.
Stock theory suggests that the stock market should assign a PEG ratio of one to every stock. This would represent theoretical equilibrium between the market value of a stock and anticipated earnings growth. For example, a stock with an earnings multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of one. (To learn more, see Introduction To Fundamental Analysis.)
PEG ratio results greater than one suggest one of the following:
Market expectation of growth is higher than consensus estimates.
Stock is currently overvalued due to heightened demand for shares.
PEG ratio results of less than one suggest one of the following:
-Markets are underestimating growth and the stock is undervalued.
-Analysts' consensus estimates are currently set too low.
-A great feature of the PEG ratio is that by bringing future growth expectations into the mix, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This makes it easier to compare different industries, which tend to each have their own historical P/E ranges.