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.