Understanding the PEG Ratio in Fundamental Analysis
The price/earnings to growth (PEG) Ratio tells you more than P/E alone
Fundamental analysis is a method of gathering an understanding of the true value of a stock, based on inside and outside influences. While this sounds rather complicated, it truly isn't if you know what to look for. Many of the ratios and tools for a fundamental analysis can be found on or calculated using the three accounting sheets—the balance sheet, income statement, and statement of cash flows.
One of these tools is the Price per Earnings (P/E) to Growth (PEG) ratio. Less well-known than its fundamental cousins, this ratio can give you a more informed view of a stock's actual value, and thus the potential for earning, once you know how to use and interpret the results correctly.
The Formula Components
The P/E ratio is a key component of the PEG ratio. You can calculate the P/E by taking a stock's current share price and dividing it by its earnings per share (EPS). This number allows you to compare the relative value of a stock against other stocks, as well as determine if the market has priced a stock higher or lower in relation to its earnings.
The other component, earnings growth, refers to the percent change from one period to the next in terms of the company's projected earnings results.
Price/Earnings to Growth Ratio
The Price/Earnings to Growth Ratio allows you to determine a stock's value, like with the P/E ratio, while also taking into consideration the company's earnings growth. This forward-looking component allows the PEG ratio to give you a more complete picture of a stock's fundamentals than you would get with the P/E alone.
You can calculate the PEG ratio by taking the P/E ratio and dividing it by the projected or actual growth in earnings:
PEG = Price to Earnings Ratio / (Projected or Actual) Earnings Growth
For example, a stock with a P/E of 2 and projected earnings growth next year of 10% would have a PEG ratio of 20 (the P/E of 2 divided by the projected earnings growth percentage of 10 = 20). This is a very high PEG, signifying that the stock is very overvalued.
The lower the PEG ratio, the more that a stock may be undervalued relative to its earnings projections. Conversely, the higher the number the more likely the market has overvalued the stock.
Interpreting the Results
Using the PEG ratio 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 viewed as overvalued and not a good choice. 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 holds true as well. If you have a stock with a very low P/E you might logically assume that it is undervalued. However, if the company does not have earnings growth projected to increase substantially, you may get a PEG ratio that is, in fact, high, indicating that you should pass on buying the stock.
Using the PEG in Fundamental Analysis
The baseline number for an overvalued or undervalued PEG ratio varies from industry to industry, but investment theory says that, as a rule of thumb, a PEG of below one is optimal. When a PEG ratio equals one, this means the market's perceived value of the stock is in equilibrium with its anticipated future earnings growth.
If a stock had a P/E ratio of 15, and the company projected its earnings to grow at 15%, for example, this gives it a PEG of one.
When the PEG exceeds one, this tells you that the market expects more growth than estimates predict, or that increased demand for a stock has caused it to be overvalued.
A ratio result of less than one says that analysts have either set their consensus estimates too low or that the market has underestimated the stock's growth prospects and value.
As you are using the other tools to conduct fundamental analysis, you are comparing the PEG ratio to the other ratios you have selected. If all of your chosen tools are showing ratios that indicate undervaluation, you may have found a stock worth investing in.
As with any analysis, the quality of results changes depending on the input data. For example, a PEG ratio may be less accurate if calculated with historical growth rates, as compared to the ratio if a company has projected higher or upward-trending future growth rates.