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.
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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.
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.
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
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%.
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:
- 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.
- 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?
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.
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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.