If you’ve been involved in investing, you’re probably familiar with using the PEG ratio to decide if a stock is a good buy at its current price. While that’s a useful tool for seeking out stocks that appear to be trading below their fundamental worth, it doesn’t always give the full picture.

Another metric, commonly referred to as the PEG ratio, goes deeper by also taking into account how quickly a company’s earnings are expected to grow. We will see what the PEG ratio is, how it works and how you can calculate it.

• What is the PEG Ratio?
• How does the PEG Ratio Work?
• What’s a Good PEG Ratio?
• How to Calculate the PEG Ratio
• How do you Calculate PEG Ratio in Excel?
• What are the Advantages and Disadvantages of the PEG Ratio?
• What is a Good 5 Year PEG Ratio?
• Is a Negative PEG Ratio Good?
• What is Apple’s PEG Ratio?
• How do you Interpret PEG Ratio?

What is the PEG Ratio? 

The PEG ratio is a form of the P/E ratio, which tells you how much investors are 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.

Read Also: What is a Stop-Loss Order?

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.

For example, suppose that XYZ Company’s P/E ratio is 20, and its expected growth rate is 35 over the next year, meaning that its PEG ratio is .57 (20 P/E ÷ 35 growth rate). Conversely, suppose that ABC Company has a P/E of 15, making it more attractive than XYZ from purely a P/E valuation. However, ABC’s expected growth rate is 10 for the next year, making its PEG ratio 1.5 (15 P/E ÷ 10 growth rate).

Although ABC has a lower price-to-earnings multiple, its lower growth rate may indicate that its stock price is overvalued compared to its expected growth over the next year. On the other hand, XYZ’s higher P/E ratio might be justified, since the company has a much higher expected growth rate.

P/E ratios for fast-growing companies such as tech startups, however, don’t necessarily give the best measure of their valuation. Oftentimes the perceived value in these companies is not in the earnings they’re producing now, but in the potential for future profits.

As such, their P/E ratios tend to be high. But that doesn’t necessarily mean they’re too richly valued. By incorporating a company’s growth rate into the valuation equation, some investors see the PEG ratio as a more accurate way to determine valuations for such stocks.

“It gives one an idea of how richly or inexpensively valued a company is relative to its growth prospects,” says Robert Johnson, professor of finance, Heider College of Business, Creighton University, and the founder of Economic Index Associates.

How does the PEG Ratio Work?

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 1 is best. When a PEG ratio is 1 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, it would have a PEG of 1.

When the PEG exceeds 1, there are two ways to read it: either the market expects more growth than fundamental estimates predict, or increased demand for a stock has caused it to be priced too high.

A ratio of less than 1 indicates that stock market analysts have set their estimates too low or that the market has underestimated the stock’s growth prospects and value.

How to Calculate the PEG Ratio 

The PEG ratio starts with the P/E ratio but takes it one step further. To get the PEG, you first divide a stock’s price by its earnings per share (EPS), just as you would to get the P/E ratio. Once you have the P/E ratio, you divide that by the expected earnings-per-share growth rate over a period of time, often five years. If it’s multiple years, you use the compound annual growth rate.

The formula looks like this:

(P/E ratio) / Expected annual EPS growth

The price-to-earnings ratio of a stock can generally be found on a stock market portal like Yahoo! Finance or from your brokerage. Expected growth rates, which are generally determined by Wall Street analysts unless a company has given its own guidance, can likely be found with your brokerage. You may have to do some calculations to determine the growth rate based on the earnings forecasts available.

For example, if a company currently has $1 in EPS and analysts forecast $1.50 in EPS in three years, its compound annual growth rate (CAGR) would be 14.5%. To determine the CAGR, you would divide the last year’s EPS by the first year’s EPS and take it to the power of 1 / (the number of years between them).

To see how we can use the PEG ratio in real life, let’s take a look at Meta Platforms (NASDAQ:FB), the tech giant and parent company of Facebook.

Meta had $13.77 in earnings per share in 2021, and it closed at a price of $216.49 on March 18. That gives the stock a P/E ratio of 15.7. The chart below shows the current EPS consensus for the company’s next four years.

Over the next four years, analysts expects Meta’s earnings per share to grow by 41%, or a compound annual growth rate of 9%. Since 15.7 divided by 9 is 1.74, Meta’s PEG ratio is currently 1.74.

If you’re wondering if that’s a good PEG ratio, you’d want to compare to its peers. Currently, the S&P 500 has a PEG ratio of 1.56, and the communications services sector to which Meta belongs has a PEG of just 1.12. That sector may not be the best comparison, however, since it includes slow-growing companies such as Verizon (NYSE:VZ) and AT&T (NYSE:T). Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG), which may be Meta’s closest peer, trades at a PEG of 2.09, making Meta look cheap by comparison.

How do you Calculate PEG Ratio in Excel?

Let’s take an example to understand the calculation in a better manner.

Example #1

A share is having a P/E Ratio of 15 and the estimated growth in earnings of the company in the coming year is expected to be at the rate of 10%. Let us calculate the PEG Ratio in this case.

Solution:

PEG Ratio is calculated using the formula given below

PEG Ratio = P/E Ratio / EPS Growth

• PEG Ratio = 15 / 10%
• PEG Ratio = 1.5

Thus, in this case, comes to be 1.5

Example #2

A share is currently trading at $30 and the EPS of the share is $2. The earnings of the company are expected to grow by 20%.

Solution:

PEG Ratio is calculated using the formula given below

PEG Ratio = (Price/EPS) / EPS Growth

• PEG Ratio = (30/2) /20
• PEG Ratio = 0.75

Thus, in this case, it comes to be 0.75.

What are the Advantages and Disadvantages of the PEG Ratio?

Below are the points that explain the advantages and disadvantages:

Advantages

• It helps the investors to compare the stocks of companies that have different levels of growth rates.
• It provides a better understanding of a stock’s valuation as compared to the P/E ratio since it also considers the rate at which the earnings of the company are expected to grow.

Disadvantages

• The ratio is not an appropriate factor for evaluating companies with fewer growth rates. The reason is that even though the companies provide fewer opportunities for growth, but they may be providing a good amount of dividend income to its investors.
• The calculation of the ratio involves usage of estimated growth rate. Since the ratio is based on estimations, it is subjected to the possibility of major deviations from the actual results.
• The ratio does not take into account the growth rate of the economy as a whole, and it is for this reason that an investor must compare the PEG of the company’s stock with the PEG across the industry in which the company operates.

What is a Good 5 Year PEG Ratio?

The Price to Earnings Growth Ratio, or PEG Ratio, measures of the value of a company against its earnings and growth rate. It is calculated by taking the historic Price to Earnings Ratio (based on last year’s diluted normalized Earnings) and dividing it by the consensus forecast EPS growth for the next year. This is measured on a TTM basis and earnings are diluted and normalized.

The PEG is a valuation metric used to measure the trade-off between a stock’s price, its earning, and the expected growth of the company. It was popularised by Peter Lynch and Jim Slater. In general, the lower the PEG, the better the value, because the investor would be paying less for each unit of earnings growth.

A PEG ratio of 1 is supposed to indicate that the stock is fairly priced. A ratio between 0.5 and less than 1 is considered good, meaning the stock may be undervalued given its growth profile. A ratio less than 0.5 is considered to be excellent.

Is a Negative PEG Ratio Good?

The implications for a negative PEG ratio might not be as bad as you think. It all depends on the reason behind the negative PEG ratio, which breaks into 2 possibilities. One spells trouble while the other might not.

The PEG ratio works like the P/E ratio, in the sense that a lower value is generally more desired. Whereas a P/E ratio is showing how much you are paying in relation to earnings, the PEG ratio expresses how much you are paying in relation to the growth.

You can think of a PEG less than 1 as meaning that you are getting more growth than you are paying for, and a PEG greater than 1 as getting less growth than what you are paying for.

This assumption is loosely accurate and widely based on Peter Lynch’s growth strategy, where he wants a growth rate at least higher than the P/E ratio. A stock priced at 17 times earnings is expected to grow 17% next year, which is how this idea is derived.

Looking back at the formula for PEG, we see there are only 2 possibilities.

1. P/E ratio is negative
2. Growth is negative

1– If the PEG ratio is negative because of a negative P/E ratio, the same logic applies as I shared earlier.

This is a situation to avoid if at all possible, because negative earnings are an extremely risky place for a business to be in. The possible gains that could be made by gambling on a comeback story usually aren’t enough to justify the enormous risk you take by investing in this kind of situation.

2– The 2nd situation isn’t as black and white. If a company’s growth is negative, it could be something you want to avoid.

But, companies lose growth every once in a while, especially temporarily. Even the greatest stocks that have compounded early investor money many times over have fell subject to negative growth from time to time.

During a depression or recession, businesses just naturally compress even if they are strong leaders of their industry. The impact of economic hardship frequently affects the whole stock market in a butterfly type effect, and so the health of earnings naturally deteriorate during those times.

It’s the scale at which earnings deteriorate that prudent investors need to monitor. If a company gets hit so hard that earnings go negative for the year, thus creating a negative P/E ratio, then again this should be absolutely avoided for most investors.

Is a Negative PEG Ratio Good or Bad?

It depends.

If the 3 year average growth is still strong, or if the company’s valuations and balance sheet are so attractive that short term under-performance can be tolerated, then I’ll consider still buying the stock. I’ll admit, it takes practice to make the distinction I’m referring to, so beginners might want to beware.

But to think that a negative PEG ratio should automatically disqualify a stock is nonsense.

One last thing you should consider is that a company with negative earnings will have wacky PEG calculations. Not only will the numerator be negative with a negative P/E ratio, but the growth will be impossible to calculate. Try to calculate growth with one year in the negative, or even two years.

It’s impossible because the growth isn’t real, and it’s for this reason that you should not bother with calculating PEG ratio if a company has negative earnings.

The negative sign throws off the calculations, and either overstates or understates what growth would’ve been. Plus, a company that’s losing money and then “grows” to lose less money is still losing money. A company like that is in a precarious state and should probably be avoided like the plague.

What is Apple’s PEG Ratio?

The price/earnings to growth ratio, or PEG ratio, is a stock valuation measure that investors and analysts can use to get a broad assessment of a company’s performance and evaluate investment risk.

In theory, a PEG ratio value of 1 represents a perfect correlation between the company’s market value and its projected earnings growth. PEG ratios higher than 1.0 are generally considered unfavorable, suggesting a stock is overvalued. Conversely, ratios lower than 1.0 are considered better, indicating a stock is undervalued.

The price-to-earnings (P/E) ratio gives analysts a good fundamental indication of what investors are currently paying for a stock in relation to the company’s earnings. One weakness of the P/E ratio, however, is that its calculation does not take into account the future expected growth of a company. The PEG ratio represents a fuller—and hopefully—more accurate valuation measure than the standard P/E ratio.

Read Also: What is Capital Budgeting?

The PEG ratio builds upon the P/E ratio by factoring growth into the equation. Factoring in future growth adds an important element to stock valuation since equity investments represent a financial interest in a company’s future earnings.

The PEG ratio doesn’t take into account other factors that can help determine a company’s value. For example, the PEG doesn’t look at the amount of cash a company keeps on its balance sheet, which could add value if it’s a large amount.

Other factors analysts consider when evaluating stocks include the price-to-book ratio (P/B) ratio. This can help them determine if a stock is genuinely undervalued or if the growth estimates used to calculate the PEG ratio are simply inaccurate. To calculate the P/B ratio, divide the stock’s price per share by its book value per share.

How do you Interpret PEG Ratio?

Using the example shown in the table of this guide, there are three companies we can compare – Fast Co, Moderate Co, and Slow Co.

• Fast Co has a price of $58.00, 2018 EPS of $2.15, and 2019 EPS of $3.23.
• Fast Co, therefore, has a P/E of 27.0x, which divided by its growth rate of 50, results in a PEG ratio of 0.54.
• Moderate Co has a price of $146.12, 2018 EPS of $11.43, and 2019 EPS of $13.25.
• Moderate Co has a P/E of 12.8x, which divided by growth in EPS of 15.9, results in a PEG of 0.80.
• Slow Co has a price of $45.31, 2018 EPS of $8.11, and 2019 EPS of $8.65.
• Slow Co’s P/E is 5.6x, which divided by growth of 6.7, results in a PEG ratio of 0.84.

Based on the above formulas and examples, Fast Co has the highest P/E ratio at 27-times, and on the surface, it may look expensive.  Slow Co, on the other hand, has a very low PE ratio of only 5.6-times, which may cause investors to think it’s cheap.

There is one major difference between these two companies (all else being equal), which is that Fast Co is growing its earnings per share at a much faster rate than Slow Co.  Given how quickly Fast Co is growing, it seems reasonable to pay more for the stock.  One way of estimating how much more, is by divided each company’s PE ratio by its growth rate.  When we do this, we see that Fast Co may actually be “cheaper” than Slow Co given its increasing EPS.

While the ratio helps adjust for growth over a period of time, it typically only takes into account a short time period, such as 1-3 years.  For this reason, one or two years of high growth may overstate the benefit of buying the faster-growing company.  The opposite is true with Slow Co.

Additionally, the ultimate driver of the value of a company – Free Cash Flow– and growth in EPS may not result in growth in cash flow (i.e. high capital expenditures required to achieve the earnings growth). While it is often a helpful adjustment to P/E, it should be considered only one of various factors when valuing a company.

PEG Ratio Formula: Understanding the Calculation

The PEG ratio formula for a company is as follows:

PEG = Share Price / Earnings per share / Earnings per Share growth rate

Example of the PEG Ratio Calculation

Using the example shown in the table at the top of this guide, there are three companies we can compare – Fast Co, Moderate Co, and Slow Co.

• Fast Co has a price of $58.00, 2018 EPS of $2.15, and 2019 EPS of $3.23.
• Fast Co, therefore, has a P/E of 27.0x, which divided by its growth rate of 50, results in a PEG ratio of 0.54.
• Moderate Co has a price of $146.12, 2018 EPS of $11.43, and 2019 EPS of $13.25.
• Moderate Co has a P/E of 12.8x, which divided by growth in EPS of 15.9, results in a PEG of 0.80.
• Slow Co has a price of $45.31, 2018 EPS of $8.11, and 2019 EPS of $8.65.
• Slow Co’s P/E is 5.6x, which divided by growth of 6.7, results in a PEG ratio of 0.84.

How to Use PEG Ratio for Stock Analysis

The price-to-earnings (P/E) ratio of a corporation divided by the earnings growth rate over a given period is called the price/earnings-to-growth ratio, or PEG ratio. By accounting for the rate of increase in earnings, it improves the P/E ratio.

Investors and analysts can use the PEG ratio as a stock valuation metric to assess investment risk and obtain a wide evaluation of a company’s performance.

Theoretically, a market valuation of a firm and its anticipated increase in earnings are perfectly correlated when the PEG ratio is 1. PEG ratios over 1.0 are usually interpreted as negative, indicating that the stock is expensive. On the other hand, ratios less than 1.0 are regarded as favorable and suggest that a stock is cheap.

Read Also: Municipal Bond ETFs vs Individual Bonds: Pros and Cons

Analysts may get a solid fundamental idea of what investors are now paying for a stock in relation to the company’s earnings by looking at the price-to-earnings (P/E) ratio. However, one shortcoming of the P/E ratio is that it does not account for a company’s anticipated future growth. Compared to the traditional P/E ratio, the PEG ratio offers a more comprehensive and, ideally, accurate valuation metric.

By including growth into the calculation, the PEG ratio improves upon the P/E ratio. Taking future growth into account adds a significant component to stock valuation because equity investments are a financial stake in the earnings of the company going forward.

To calculate a stock’s PEG ratio you must first figure out its P/E ratio. The P/E ratio is calculated by dividing the per-share market value by its per-share earnings. From here, the formula for the PEG ratio is simple:

The PEG calculation can be done using a projected annual growth rate for a longer period of time than five years, but growth projections tend to become less accurate the further out they extend.

PEG Ratio vs Price-to-Earnings Ratio: What is the Difference?

One common method for figuring out valuation is the price-to-earnings, or P/E ratio, which is the comparison of the stock price to earnings per share. However, simply understanding the P/E is equivalent to a football coach solely focusing on the offense of his opponent while ignoring its defense, special teams, and coaching philosophy. Along with delving deeper into a company’s fundamentals, investors must also learn about and apply a few more methods in order to truly appreciate a stock’s value and trade more successfully.

The P/E ratio can sometimes steer investors in the wrong direction. Imagine two stocks—stock A and stock B—in the same sector. Stock A has a P/E of 10, and stock B has a P/E of 15. At first glance, stock A would seem to be a better value than stock B because investors can buy it for a lower price compared to earnings than its competitor.

Not so fast. The P/E ratio doesn’t take into account other key factors that help determine a stock’s price, including the company’s growth.

For example, if stock A has a P/E of 10 and stock B’s P/E stands at 15, it tells nothing about the growth trajectory of the companies. If stock B is growing at an 18% clip and stock A is pushing along at a 10% rate, many investors might prefer to pay 15 times for 18% growth than 10 times for 10% growth. 

In other words, most metrics by themselves can’t be used in a vacuum; you have to look at growth rates and risk together.

Price/earnings-to-growth ratio

The price/earnings-to-growth, or PEG, ratio tells a more complete story than P/E alone because it takes growth into account. Investors are often willing to pay a higher premium for greater earnings growth, whether it’s from past growth or estimated future growth.

The lower the PEG ratio, the more undervalued the stock. Let’s say that stock A, with its P/E of 10, has forward annual earnings growth estimated at 10% for the next five years. To determine the PEG ratio, the P/E ratio is divided by earnings growth, in this case yielding a PEG of 1. Stock B, with its P/E of 15, has forward annual earnings growth estimated at 20% over the next five years, for a PEG of 0.75. Stock B has a lower PEG than stock A, meaning that by this measure, it’s actually the better value. Generally, a PEG below 1 means this metric considers a stock undervalued.

When a company doesn’t have earnings, investors can compare its stock price to its sales to help determine value.

The ratios of price-to-earnings (PE) and price-to-earnings growth (PEG) are quite comparable. The stock price of the company in relation to its earnings-per-share (EPS) can be understood using both ratios. The PEG ratio accounts for the anticipated growth rate of earnings, which is the only difference between the two measures.

The Importance of PEG Ratio in Investment Decisions

One could argue that the PEG ratio is a more significant indicator of value than the P/E ratio by itself. The PEG ratio assists an investor in assessing a company’s valuation in relation to its potential for future profits growth by accounting for growth.

The PEG ratio also introduces a degree of uncertainty because it necessitates estimating future growth. Therefore, even while the PEG ratio might be a helpful indicator when assessing a possible investment, it shouldn’t take the place of a thorough examination of a company’s financial statements, management, industry, and other pertinent aspects.

1. Holistic Valuation: The PEG ratio facilitates a holistic stock evaluation by integrating its price-to-earnings (P/E) Ratio and earnings growth rate. This comprehensive method empowers investors with a nuanced understanding of the stock’s value, harmonizing existing earnings with prospective growth opportunities. By blending these crucial factors, the PEG ratio offers a more complete and insightful perspective, enabling investors to make informed decisions. 

This approach not only assesses the present financial performance but also anticipates the company’s future trajectory, allowing investors to gauge the stock’s potential accurately. In essence, the PEG ratio serves as a valuable tool, ensuring a well-rounded assessment that encompasses both current profitability and growth prospects.

2. Comparative Analysis: PEG ratios easily compare companies within the same industry. By normalizing the P/E ratio with the growth rate, investors can identify stocks that are not only undervalued but also have strong growth prospects, enabling better investment decisions.

3. Risk Assessment: The PEG ratio aids investors in gauging a stock’s risk. A low PEG ratio shows that a stock is undervalued concerning its growth prospects, highlighting an advantageous risk-to-reward ratio. This information empowers investors to manage their risk exposure proficiently. 

By indicating undervalued stocks with strong growth potential, investors can make strategic decisions, maximizing their chances of favorable returns while minimizing the associated risks. The PEG ratio thus serves as a valuable tool in assisting investors in making informed and prudent investment choices.

4. Long-Term Investment Focus: PEG ratio emphasizes earnings growth over time. By focusing on a stock’s future earnings potential, investors can make decisions easily that align with their long-term investment goals, fostering a patient and strategic approach to investing.

5. Quick Screening Tool: PEG ratios serve as efficient screening tools, allowing investors to quickly identify stocks with strong growth prospects trading at reasonable valuations. This expedites the stock selection process, saving time and effort in the research and analysis phase.

How to Calculate PEG Ratio for Dividends Stocks

The price/earnings to growth (PEG) ratio is a proven metric for investors looking to determine the value of an equity, but it needs to be tweaked when dealing with dividend stocks. That’s where the dividend-adjusted PEG ratio comes into play.

The dividend adjusted PEG ratio, or PEGY (price/earnings to growth and dividend yield) for short, is a modified version of the popular PEG ratio that accounts for dividend income. This crucial detail makes it easier for investors to compare the returns of mature companies and newly established high-growth companies.

To calculate the PEGY ratio, all one needs to do is divided the P/E ratio by the sum of the projected earnings growth rate and dividend yield.

For example, if a company has a P/E ratio of 10, a projected earnings growth rate of 20% and a dividend yield of 4%, its PEGY ratio is 0.42. That is:

10 / (20 + 4) = 0.42

In general, a PEGY ratio below 1.0 means a stock has a high dividend yield or potential growth and is currently undervalued as far as the price is concerned. Companies with a PEGY ratio below 1.0 are considered good investment opportunities.

To illustrate: Apple Inc. (AAPL) has a dividend yield of 1.18%, an expected growth rate of 10.77% next year (year ending September 2020) and a P/E ratio of 19.89. As a result, its PEGY is 1.66.

By comparison, Coca-Cola Co (KO) yields 3.09% and is expected to grow 7.14% next year. With a P/E ratio of 24.61, KO’s PEGY is 2.40.

Under this scenario, Apple is a more attractive company to invest in than Coca-Cola.

PEG Ratio and Growth Stocks: A Winning Combination

Finding stocks with strong growth potential is an essential part of being a successful investor. A lot of investors have chosen growth stocks in particular because of their potential for capital growth. Finding attractive growth stocks, however, can be difficult, particularly for novice investors. The price/earnings to growth (PEG) ratio is one tool for identifying growth firms. A measure used to assess a stock’s worth based on its potential for earnings growth is the PEG ratio.

Growth stocks are shares of businesses with the potential to grow faster than the market as a whole. Since these businesses are usually just getting started, it is anticipated that their earnings will increase more quickly than the market as a whole. Growth stocks are thought to be riskier than other stock classes, but they also often offer investors a bigger potential for wealth appreciation.

A valuation tool called the PEG ratio considers a company’s present valuation as well as its potential for profits growth. It is computed by dividing the company’s earnings growth rate by the price-to-earnings (P/E) ratio. When the PEG ratio is less than one, it’s deemed cheap, and when it’s greater than one, it’s deemed overvalued.

The PEG ratio can be a useful tool for investors looking to identify promising growth stocks. A lower peg ratio indicates that the stock is undervalued, meaning that the market has not fully priced in the earnings growth potential of the company. On the other hand, a higher PEG ratio indicates that the stock is overvalued, meaning that the market has already priced in the earnings growth potential of the company. It is important to note that the PEG ratio should not be used in isolation and should be used in conjunction with other valuation metrics.

Examples of Growth Stocks with Promising PEG Ratios: One example of a growth stock with a promising PEG ratio is Amazon (AMZN). The company has a PEG ratio of 1.29, indicating that it is slightly overvalued but still has significant earnings growth potential. Another example is Square Inc (SQ), which has a PEG ratio of 0.98, indicating that it is undervalued and has significant earnings growth potential.

Identifying promising growth stocks is a critical aspect of successful investing. The PEG ratio is a useful tool for investors looking to identify undervalued growth stocks with significant earnings growth potential. However, it is important to use the PEG ratio in conjunction with other valuation metrics and not in isolation.

PEG Ratio and Earnings Growth: What to Look For

The price/earnings to growth ratio (PEG ratio) is a stock’s price/earnings ratio (P/E ratio) divided by its percentage growth rate. The resulting number expresses how expensive a stock’s price is relative to its earnings performance.

For example, let’s say you’re analyzing a stock that is trading with a P/E ratio of 16. Suppose the company’s earnings per share (EPS) have been and will continue to grow at 15% per year. By taking the P/E ratio (16) and dividing it by the growth rate (15), the PEG ratio is calculated as 1.07.

But things are not always so straightforward when it comes to determining which growth rate should be used in the calculation. Suppose instead that your stock had grown earnings at 20% per year in the last few years, but was widely expected to grow earnings at only 10% per year for the foreseeable future.

To compute a PEG ratio, you need to first decide which number you will plug into the formula. You could take the future expected growth rate (10%), the historical growth rate (20%), or any kind of average of the two.

Forward PEG

The first method of calculating PEG is to use a forward-looking growth rate for a company. This number would be an annualized growth rate (i.e., percentage earnings growth per year), usually covering a period of up to five years. Using this method, if the stock in our example was expected to grow future earnings at 10% per year, its forward PEG ratio would be 1.6 (P/E ratio of 16 divided by 10).

Trailing PEG

Some people use another method, in which the stock’s trailing PEG ratio is reported, calculated by using trailing growth rates. The trailing growth rate could be derived from the last fiscal year, the previous 12 months, or some sort of multiple-year historical average. Turning again to the stock in our example, if the company had grown earnings at 20% per year for the past five years, you could use that number in the calculation, and the stock’s PEG would be 0.8 (16 divided by 20).

Which Approach Should You Use?

Neither one of these approaches to a PEG ratio calculation is wrong—the different methods simply provide different information. Investors are often concerned about what price they are paying for a stock relative to what it should earn in the future, so forward growth rates are often used. However, trailing PEG ratios can also be useful to investors, and they avoid the issue of estimation in the growth rate since historical growth rates are hard facts.

Regardless of what type of growth rate you use in your PEG ratios, what matters most is that you apply the same method to all the stocks you look at to ensure that your comparisons are accurate.

Generally speaking, however, a PEG ratio of less than 1 suggests a good investment, while a ratio over 1 suggests less of a good deal. Remember, PEG ratios don’t tell you anything about the future prospects of a company (i.e., a company sure to go bankrupt will likely have a very low PEG ratio, but that doesn’t mean it’s a good investment).

The Limitations of PEG Ratio: What to Consider

In the world of finance, the term “PEG” refers to the process by which investors compare a stock’s price-to-earnings (P/E) ratio to its earnings growth rate in order to determine the stock’s value. This Ratio offers a thorough evaluation of a business’s valuation by taking into account both its projected growth and current earnings.

Below are some of the limitations of PEG ratio:

1. Reliance on Future Projections: The PEG ratio heavily depends on accurate earnings growth forecasts. Relying on these predictions can be risky, as they might not always materialize as expected, leading to inaccurate valuations and investment decisions.

2. Ignores Company-Specific Factors: The PEG ratio overlooks company-specific factors such as management quality, competitive advantages, and market dynamics. It assumes that all companies with similar PEG ratios are equal, which might not be the case, leading to misguided investment choices.

3. Limited for Comparing Different Industries: Comparing PEG ratios across different industries can be misleading. Industries with inherently different growth patterns might not be accurately evaluated using the same PEG threshold, making it challenging to assess relative valuations across sectors.

How to Calculate PEG Ratio for International Stocks

A P/E ratio on its own is a time-honored metric that investors use to seek out companies that may be trading below their fundamental value. The basic P/E formula simply divides the current stock price by the company’s earnings per share. 

So let’s say a company has a P/E ratio of 10. In effect, that means you’d be paying $10 for every $1 of earnings, making it relatively expensive compared with a stock with a P/E of 3, for which you’d be paying $3 for every $1 of earnings.

P/E ratios for fast-growing companies such as tech startups, however, don’t necessarily give the best measure of their valuation. Oftentimes the perceived value in these companies is not in the earnings they’re producing now, but in the potential for future profits. As such, their P/E ratios tend to be high. But that doesn’t necessarily mean they’re too richly valued. By incorporating a company’s growth rate into the valuation equation, some investors see the PEG ratio as a more accurate way to determine valuations for such stocks.

“It gives one an idea of how richly or inexpensively valued a company is relative to its growth prospects,” says Robert Johnson, professor of finance, Heider College of Business, Creighton University, and the founder of Economic Index Associates.

How to calculate the PEG ratio

The formula 

To calculate PEG ratio, you first divide the company’s share price by its earnings per share (EPS), then divide the resulting figure by its EPS growth rate.

EPS is a metric used by investors to evaluate a company’s profitability on a per-share basis. The higher the EPS, the more profitable a company is. In essence, EPS is determined by dividing a company’s earnings by its total number of shares outstanding. However, there are several ways to calculate EPS, including basic and diluted. The calculation also can be based on either historical or projected earnings.

The EPS growth rate for the purposes of the PEG ratio is a company’s forecasted rate of earnings growth over a period of time. This is based on estimates made by third-party analysts. 

PEG Ratio and Market Volatility: How to Adjust

Market volatility is a term that is frequently thrown around in financial circles, but what does it really mean? In simple terms, market volatility refers to the rapid and significant price fluctuations that occur in financial markets. These fluctuations can be caused by a variety of factors, including economic events, geopolitical tensions, and investor sentiment. Understanding market volatility is crucial for investors and traders as it can have a significant impact on investment decisions and portfolio performance.

Market volatility can have a profound impact on investment decisions. During periods of high volatility, investors may become more risk-averse and seek safer investment options, such as government bonds or stable dividend-paying stocks. On the other hand, some investors may see increased volatility as an opportunity to capitalize on price fluctuations and generate higher returns through active trading strategies. understanding one’s risk tolerance and investment goals is crucial in determining the appropriate response to market volatility.

By understanding the P/E ratio and implementing appropriate strategies, investors can make informed decisions to maximize their returns in volatile markets.

1. Understanding the P/E ratio: The P/E ratio is calculated by dividing the market price per share by the earnings per share (EPS). It helps investors gauge the relative value of a stock and determine whether it is overvalued or undervalued. A high P/E ratio indicates that investors have high expectations for future earnings growth, while a low P/E ratio suggests that the market has lower expectations or the company is undervalued.

2. Identifying undervalued stocks: In volatile markets, stock prices can experience significant fluctuations. By focusing on stocks with low P/E ratios, investors can identify potential opportunities for undervalued investments. However, it is essential to conduct thorough research and consider other fundamental factors, such as the company’s financial health, growth prospects, and industry trends, to ensure that the low P/E ratio is justified and not a result of underlying issues.

3. Comparing P/E ratios within industries: When analyzing P/E ratios, it is crucial to compare them within the same industry. Different industries have varying growth rates and risk profiles, which can impact the acceptable range for P/E ratios. Comparing a company’s P/E ratio to its industry peers’ can provide insights into its relative valuation and whether it is trading at a premium or discount. For example, a company with a lower P/E ratio compared to its competitors might indicate a potential undervaluation.

4. Utilizing forward P/E ratios: While the historical P/E ratio is valuable, it is also essential to consider the forward P/E ratio. The forward P/E ratio uses estimated future earnings rather than historical earnings. This ratio provides a glimpse into the market’s expectations for a company’s future growth. Investors should compare the historical and forward P/E ratios to evaluate whether the market’s expectations align with their own projections.

5. Diversification and risk management: Volatile markets can be unpredictable, and investing solely based on P/E ratios may not be sufficient. It is crucial to diversify investments across different sectors, asset classes, and geographies to spread risk. Diversification helps mitigate the impact of market volatility on an investment portfolio and can provide stability during turbulent times. While analyzing P/E ratios can be a valuable tool, it should be complemented with a comprehensive risk management strategy.

6. Seeking professional advice: Investing in volatile markets can be challenging, and seeking professional advice from financial advisors or investment managers can provide valuable insights and guidance. These professionals have expertise in analyzing market trends, identifying investment opportunities, and managing risk. They can help investors make informed decisions based on P/E ratios and other relevant factors, ultimately maximizing returns and minimizing potential losses.

Strategies for investing in volatile markets based on the P/E ratio require a comprehensive understanding of the ratio itself, as well as the broader market dynamics. By identifying undervalued stocks, comparing P/E ratios within industries, utilizing forward P/E ratios, diversifying investments, and seeking professional advice, investors can navigate volatile markets with a higher probability of success. However, it is essential to conduct thorough research, consider multiple factors, and adapt strategies as market conditions evolve