Understanding the PEG Ratio

Posted by Brendan Flaherty

May 31, 2016 5:45:59 PM

The Price/Earning to Growth Ratio or the PEG ratio is calculated as (price/earnings ratio) / (earnings growth rate). The PEG ratio is useful because it standardizes P/E ratios for growth. It gives a relative measure of value and facilitates comparing firms with different growth rates.

If the growth rate exceeds the P/E ratio, the numerical value is less than 1.0 and suggests that the stock is undervalued. If the P/E ratio exceeds the growth rate, the PEG ratio is greater than 1.0. The higher the numerical value, the higher the valuation, and the less attractive the stock. A PEG of 1.0 to 2.0 may suggest the stock is reasonably valued, and a ratio greater than 2.0 may suggest the stock is overvalued. Most importantly, the numerical value that determines under- and overvaluation is determined by the financial analyst or investor.

As with the price/earnings, price/sales, and price/equity ratios, the PEG ratio can have significant limitations. However, because the PEG ratio standardizes for growth, it offers one major advantage over P/E ratios: The PEG ratio facilitates comparisons of firms in different industries that are experiencing different growth rates.

Since calculating PEG ratio requires P/E ratio, for firms that do not post earnings, the only alternative is to use a forecasted earnings number. The calculations of a low PEG and a low P/E ratio may be a good starting point, but are probably not sufficient to conclude that the stock is a good purchase.

The statement “If a company does not pay dividends, it will have a greater PEG ratio” is not just a generalization. The proponents of the PEG ratio believe that companies with a low PEG ratio will have higher rates of returns. The proponents factor in both the dividend yield and the growth rate in the numerator of the PEG ratio.

Topics: Course 3: Investment Planning