The price-to-earnings-to-growth (PEG) ratio is a modified version of the price-to-earnings ratio (P/E), which is a popular way for investors to measure the relative valuation of two stocks. The PEG ratio takes the extra step of comparing the P/E to the rate of growth, which can give you a more informed view of a stock's actual value, and thus, the potential for earning.
Here's how to calculate and interpret the results of the PEG ratio.
What Is the PEG Ratio?
The PEG ratio is a form of the P/E ratio, which tells investors how much Wall Street is willing to pay for every $1 in company earnings. In general, a lower P/E is considered better because it suggests that the price is backed up by fundamentals, rather than speculation.
One of the limitations of P/E is that it doesn’t factor in the growth in underlying earnings. Back when Sam Walton first began opening Walmart stores, P/E analysis wouldn't have accounted for rapid growth and investments in expansion. To make up for this shortcoming in P/E, investors use the price-to-earnings-to-growth (PEG) ratio. This could give you a better idea of the stock's level of valuation.
Like P/E, a lower PEG is generally considered preferable to a higher PEG.
How to Calculate the PEG Ratio
To calculate the PEG, an investor must first calculate the P/E. To do that, take the share price and divide it by the earnings per share (EPS). 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 conjunction with a stock's P/E can tell a very different story than using P/E alone. A stock with a high P/E might be viewed as overvalued and not a good investment. Calculating the PEG ratio on that same stock, assuming it has good growth estimates, can actually yield a lower number and indicate that the stock may still be a good buy.
The opposite holds true as well. If you have a stock with a low P/E, you might logically assume that it is undervalued. However, if the company does not have expectations of significant earnings growth, you may get a high PEG ratio, indicating that you should pass on buying the stock.
What's a Good PEG Ratio?
The baseline number for an overvalued or undervalued PEG ratio varies from industry to industry, but as a rule of thumb, a PEG of below one is optimal. When a PEG ratio is exactly one, 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 fundamental estimates predict, or that increased demand for a stock has caused it to be overvalued.
A ratio 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.
Limitations of the PEG Ratio
The biggest danger in using the PEG ratio to find cheap stocks comes from being overly optimistic. Growth estimates are just that—estimates. Using the most conservative figure available helps to avoid overpaying for a stock that doesn't deliver on growth expectations. By banking too much on the promise of the future, a stock that would otherwise be worthless might appear to be a great bargain.
When investors as a whole become overly optimistic, this creates a stock market bubble—like the dot-com and housing bubbles that "popped" in 2000 and 2008, respectively. When investors realize that their optimism allowed 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, an analyst could calculate a different PEG ratio depending on whether they use historical growth rates or company projections.
Dividend-Adjusted PEG Ratio
A simple PEG ratio works best for companies that don't offer dividends. However, many stocks do come with dividends, especially major corporations and blue-chip stocks. Those dividends cut into the company's true EPS, which throws off the whole formula.
If the stock you're watching offers a dividend, you might prefer to use a dividend-adjusted PEG ratio. Calculating it requires a slight adjustment to the standard PEG ratio formula. Instead of simply dividing the P/E by the expected earnings growth, you first add together the expected earnings growth and dividend yield. You then divide the P/E by that figure.
- The price-to-earnings-to-growth (PEG) ratio is a formula that compares a stock's price to its earnings and rate of growth.
- The PEG ratio is calculated by dividing the P/E ratio by the EPS growth rate.
- This formula can help investors find stocks that are undervalued (or avoid stocks that are overvalued).
- Dividends will throw off the PEG ratio, so it's important to use a slightly altered formula for stocks that issue significant dividends.