The price-to-earnings-to-growth (PEG) ratio is a stepped up version of the price-to-earnings ratio (P/E). Both are common ways to compare two stocks and to measure their relative valuation. The PEG ratio takes the extra step beyond the P/E by adding the rate of growth of a given stock as a factor. This added metric can give you a more informed view of a stock's true value, and thus, how much you might earn over time.
Here's how to calculate and interpret the results of the PEG ratio.
- The price-to-earnings-to-growth (PEG) ratio is a formula that compares a stock's price to its earnings and rate of growth.
- To calculate the PEG ratio of a given stock, divide the P/E ratio by the EPS growth rate.
- This formula can help to find stocks that are priced below their value (or avoid stocks that are priced too high for their value).
- Dividends will throw off the PEG ratio, so there is a slightly altered formula you can use for stocks that issue dividends.
What Is the PEG Ratio?
The PEG ratio is a form of the P/E ratio, which tells you how much Wall Street is willing to pay for each $1 in company earnings. For the most part, a lower P/E is thought to be better because it suggests that the price is backed up by fundamentals, rather than by guesswork.
One of the limits of P/E is that it doesn’t factor in the growth in underlying earnings. Back when Sam Walton first began opening Walmart stores, using the P/E on its own wouldn't have accounted for the rapid growth that would soon come from all the money being spent on expansion. To make up for this flaw in P/E, you can use the price-to-earnings-to-growth (PEG) ratio. The extra factor, if you know it, could give you a better idea of the stock's true value.
As with P/E, most traders view a lower PEG is as much better than a higher PEG, because it means a stock stands to be worth more in the future than its current purchase price.
How to Calculate the PEG Ratio
To find the PEG, you must first calculate the P/E. To do that, take the share price and divide it by the earnings per share (EPS). EPS is a basic way to express how much income or profit is earned for each share on the market. You can find a stock's EPS, along with its share price, on almost any stock quote website. Once you have the P/E, you simply divide that by the growth in earnings per share to arrive at the PEG ratio.
How the PEG Ratio Works
Using the PEG ratio in tandem with a stock's P/E can tell a very different story than using P/E alone. Take the example of a stock with a high P/E, which might be viewed as overvalued and not a good investment. If that same stock happens to have good growth estimates and you were to calculate the PEG ratio, you might come up a lower number, which would tell you that the stock may still be a good buy.
On the other hand, if you have a stock with a low P/E, you might assume that it is undervalued. But if the company is having a rough year and does not expect major growth, you may get a high PEG ratio, which would mean that you should pass on buying the stock.
What's a Good PEG Ratio?
The standard number for a safe or even great PEG ratio varies from one industry to the next, but as a rule of thumb, a PEG of below one is best. When a PEG ratio is one on the dot, the market's perceived value of the stock is in balance with what you can expect of its future earnings growth.
If a stock had a P/E ratio of 15, and the company projects its earnings to grow at 15%, for example, this gives it a PEG of one.
When the PEG exceeds one, there are two ways to read it. Either this tells you that the market expects more growth than fundamental estimates predict, or that increased demand for a stock has caused it to be priced too high.
A ratio of less than one says that stock market analysts have either set their estimates too low or that the market has underestimated the stock's growth prospects and value.
Limits of the PEG Ratio
The biggest danger in using the PEG ratio to find cheap stocks comes from being too tied to high hopes. Keep in mind that growth estimates are just that; they are not set in stone or backed by a promise. Using the most conservative figure you have access too can help you avoid paying too much for a stock that doesn't grow as you might expect it to. By banking too much on the promise of the future, a stock might appear to be a great bargain, though in fact is quite worthless.
When traders as a whole become too optimistic, the result is a stock market bubble. This happened in 2000 with the dot-com bubble, and again in 2008 with the housing bubble. As you may recall, it wasn't too long before both "popped." When traders realize that their hopes were too high, which had led stock prices to rise too high, those bubbles burst with sudden stock crashes.
As with any analysis, the quality of results changes as the input data does. For example, depending on whether you use a company's future projections, or its past growth rates, as the "G" in the PEG ratio, you may come up with two figures.
Dividend-Adjusted PEG Ratio
A simple PEG ratio works best for stocks that don't offer dividends. However, many stocks do, such as major corporations and blue-chip stocks. Those dividends cut into the company's true EPS, which throws off the whole formula.
But there is a way to account for this factor. If the stock you're watching offers a dividend, you might prefer to use a dividend-adjusted PEG ratio. To come up with this figure you must slightly adjust the standard PEG ratio. Instead of simply dividing the P/E by the expected earnings growth, you must first add the expected earnings growth to the dividend yield. You then divide the P/E by that output.