# Understanding the PEG Ratio in Fundamental Analysis

## The Price/Earnings to Growth (PEG) Ratio Tells You More than P/E Alone

In my previous articles in this series on fundamental analysis, I focused some of the better-known metrics like Earnings per Share and Price to Earnings Ratio. Though less well-known than its fundamental cousins, the Price/Earnings to Growth or PEG ratio can give you a more informed view of a stock's potential if you know how to use it correctly.

### P/E Ratio Basics

For a quick review -- and because it is a key component of the PEG ratio -- remember that the P/E is calculated by taking the current share price and dividing it by the earnings per share (EPS).

This number allows you to compare the relative value of a stock as well as determine if a stock's price is high or low in relation to its earnings.

### Price/Earnings to Growth (PEG) Ratio

What the Price/Earnings to Growth Ratio allows you to do is to determine a stock's value while taking into consideration the company's earnings growth. This forward-looking component allows the PEG ratio to give you a complete picture of a stock's fundamentals than just P/E alone.

The PEG is calculated by taking P/E and dividing it by the projected growth in earnings, or...

PEG = Price to Earnings Ratio / Projected Earnings Growth

For example, a stock with a P/E of 20 and projected earnings growth next year of 10% would have a PEG ratio of 2 (as the P/E of 20 divided by the projected earnings growth percentage of 10 = 2). The lower the PEG ratio, the more a stock may be undervalued relative to its earnings projections.

Conversely, the higher the number the more likely it is that a stock is overvalued.

### P/E Ratio versus PEG Ratio

Using the PEG in conjunction with a stock's P/E can tell a very different story than using P/E alone.

A stock with a very high P/E might be looked at as overvalued and not a good buy. Calculating the PEG ratio on that same stock -- assuming it has good growth estimates -- can actually yield a lower number, indicating that the stock may still be a good buy.

The opposite is true as well. If you have a stock with a very low P/E you might logically assume that it is undervalued. But if earnings growth is not projected to increase substantially, you may get a PEG ratio that is, in fact, high, indicating that you should pass on buying the stock.

### The Bottom Line

The raw number for an over or undervalued PEG ratio varies from industry to industry, but the general rule of thumb is that a PEG of below one is optimal.

As with all fundamental analysis, numbers change depending on the input data. For example, a PEG ratio may be less accurate if using historical growth rates when future growth rates are projected to be more (or less). As always, garbage in, garbage out.

### More on Fundamental Analysis Calculations

- Earnings per Share - EPS
- Price to Earnings Ratio - P/E
- Price to Book -P/B