The PEG Ratio is a stock valuation tool for investment analysis. Its purpose is to evaluate and the trade off between the price of a stock, the earnings per share, and the company’s expected growth rate.
Peter Lynch, when managing the ultra successful Fidelity Magellan mutual fund, popularized the ratio. He writes in his book “One Up On Wall Street”: “The P/E ratio of any company that’s fairly priced will equal its growth rate.”
Calculate PEG Ratio
The PEG Ratio calculation is:
(Price/Earnings) / Expected Growth Rate = PEG Ratio
How to Use the PEG Ratio
Lynch recommended that you first find attractive companies, and then use the PEG ratio as a tool to evaluate and compare the different companies.
In general, companies with high ratio (over 1.0) would be more overvalued than companies with a low ratio (under 1.0).
Examples: Company A is selling for $30, has earnings of $2, and an expected growth rate of 15%. PEG Ratio = 1
Company B is selling for $60, has earnings of $4, and an expected growth rate of 20%. PEG Ratio = 0.75
Company C is selling for $45, has earnings of $1, and an expected growth rate of 30%. PEG Ratio = 1.5
The Price Earnings Growth Ratio would indicate company B has the most undervalued price. Company C is the fastest grower but the most overvalued price. Company A is expected to grow the slowest and is fairly valued.
Advantages of PEG Ratio
The main value of the PEG ratio is that it is an easy calculation and assigns a relative value to expected future earnings growth of a company. In other words, it allows the analyst to compare the valuation of companies with different growth rates. It is a more thorough picture of valuation than the P/E ratio alone.
Disadvantages of PEG Ratio
The PEG ratio is rule of thumb, or an approximation; not a mathematical certainty by any means. In addition, the formula is only as good as its inputs.
The greatest chance for inaccurate input would be the future growth rate assumption. Anytime an analyst makes assumptions about the future it can be incorrect.
The ratio has limitations in measuring companies with low growth. As an example, a mature company may have good earnings and a solid dividend, but a slow growth rate. Obviously, a company growing earnings at 1% is probably not going to sell at a P/E ratio of 1.
Stock Valuation Tools
The PEG Ratio should be one of the tools in your valuation tool box. There are MANY valuation tools to explore in the Investment Analysis Category of this blog.
Use stock valuation tools such as the PEG Ratio to evaluate and compare companies. The ratio provides insight into the trade off between the price of the stock, the earnings per share, and company’s expected growth rate!
Related Reading: Shiller PE 10