Summary - Fundamental analysis is an important part of any investment strategy. Investors have many tools that can help them determine if a company is appropriately valued such as a balance sheet. When investing in stocks, one of the key ratios that is used is the price-to-earnings (P/E) ratio. In simple terms, this tells an investor how much they are paying to purchase $1 or a company’s earnings.
However, while the P/E ratio can show a company as a good investment, it doesn’t take into account future earnings. This is why many investors have come to supplement the P/E ratio with another measurement tool the price-to-earnings growth (or PEG) ratio. This ratio takes into account a company’s future earnings growth to give a more accurate picture of a stock’s valuation.
PEG is particularly important for certain growth stocks that may historically have periods of higher and lower growth when compared to the overall stock market. These stocks may have a forecasted EPS growth rate that supports a P/E ratio that would make a stock seem overvalued. Likewise, a PEG ratio for a mature company may show that what many investors consider to be a fair P/E ratio is actually indicative of a stock that is overvalued.
However, like other ratios, the PEG ratio is most helpful when comparing a stock price to others in its industry or sector. Some sectors, such as technology, may have much higher future earnings growth. However, the accepted rule among investors is that a PEG of greater than 1 is considered to indicate a stock price that is too high based on expected earnings growth. A PEG of less than 1 is considered to indicate a stock that is undervalued based on projected earnings growth.
Legendary investment manager Peter Lynch once wrote: "The P/E ratio of any company that's fairly priced will equal its growth rate". Certainly, a stock's price-to-earnings ratio (P/E ratio) is widely considered a reasonably accurate measure of a company's valuation, and can sometimes be used as a way of comparing one company against another.
The P/E ratio is a measurement of how much an investor is paying to buy $1 of a company’s earnings or profit. To calculate the P/E Ratio you simply divide the stock price by the earning per share:
P/E Ratio = Stock Price/Earnings per share (EPS)
For example, if a company is reporting earnings of $3 per share and their stock is selling for $30 per share, the P/E ratio is 10 ($30 per share/$3 per share).
While there is no “standard” P/E Ratio for all stocks and sectors, investors can generally find that different industries will have a P/E ratio that is considered normal. For example, it’s not uncommon to find technology companies with a P/E ratio of 20 or higher. This is due in part because these companies include many growth stocks that are anticipated to increase in share price and EPS. Financial services companies might have P/E ratios in the low teens. For investors this means rather than one-size-fits-all, the objective is to ensure that two companies in the same industry have a similar P/E ratio. However, if all companies in a particular sector begin to have P/E ratios that are abnormally high or low (based on their historical pattern) it may indicate that the stock is overvalued or undervalued. For example, in the months leading up to the real estate crash of 2007, the P/E ratio of real estate stocks soared. A similar phenomenon occurred before the tech stock crash in the early 2000s.
However, like many ratios, the P/E ratio has limitations. The primary limitation of P/E ratio is that it is limited to a moment in time. It gives you an accurate assessment of where one company compares to another at that moment. However, to get a more accurate view of whether a stock is overvalued or undervalued requires knowledge of the anticipated growth rate between the two companies. For example, a company with a P/E of 30 with an anticipated growth rate of 50% may be much more undervalued than a company with a more enticing P/E of 20, but with an anticipated growth rate of 5%, which is fairly typical of a mature company.
Because of the limitations of the P/E ratio, investors will frequently use a ratio that factors in a company’s projected or historical growth rate to get a more accurate picture of a stock’s valuation. This number is known as the PEG ratio and it is the focus of this article. In this article we’ll define the PEG ratio and provide examples, we’ll also review how to interpret the PEG ratio and review some of the limitations of this ratio.
What is the price-to-earnings growth (PEG) ratio?
This limitation spawned the need for a new metric, the ration of the P/E to growth (or PEG). The formula for PEG is as follows:
P/E Ratio/Earnings per share (EPS) growth Rate
If you were to put this formula into a sentence, it would say that the PEG ratio is a calculation that helps investors determine whether a stock's price is overvalued or undervalued by not only looking at their current earnings but also looking at their expected future earnings growth.
To test Lynch’s theory, PEG would imply that if a company had a “Fair P/E ratio” than it should have a PEG of around 1.
If: Fair P/E Ratio = EPS Growth Rate
Than: P/E Ratio/EPS Growth Rate = 1
How to interpret the PEG ratio
If the PEG ratio is greater than 1, the implication is that the stock is more expensive (in relative terms). A PEG ratio below 1 means that a stock is trading at below its fair value.
While it’s true that the P/E ratio is a multiple and the PEG is a percent, it’s important to focus on the true objective and that is to determine whether a stock is properly valued. To that end, the PEG is considered to be more accurate than simply looking at a company’s P/E ratio when determining proper valuation.
For example, by definition, a high P/E ratio typically signals to investors that a stock is overvalued. However, if the company has high growth estimates than calculating the PEG can show a very different picture and one that could suggest the stock is still a buy. In our earlier example, a company with a P/E ratio of 30 might be considered to be overbought, but if it is forecasting a growth rate of 50% than its PEG ratio suggests. Using the formula:
PEG = P/E Ratio/Growth Rate, the company would have a PEG ratio of 0.6
PEG = 30/50 = 0.6
In this case, the PEG number suggests that either analysts are setting their expectations too low or that the stock’s growth is being undervalued. In either case, the ratio suggests the stock has room to grow.
The opposite is also true. If a company has a P/E range of 8 which may be lower than expected or lower than others in its sector, the assumption could be that the stock is undervalued. However, a closer look may indicate that the company is expecting only about 5% for the growth for the year. While that growth rate is certainly not poor when you perform the PEG calculation you come up with:
PEG = 8/5 = 1.6
In this case, the company may very well have a difficult time increasing their share price above its current level.
Limitations of the P/E Growth ratio
One of the basic limitations of PEG is that it does not forecast growth beyond the period being measured. If a company has a stellar PEG number, it says nothing about the company’s future growth prospects. It also does not provide a context for the growth number. For example, that growth could be due to a one-time event. Also, when compared with other analysis tools such as a discounted cash flow analysis, the PEG ration tends to undervalue the companies with the highest growth rates. Another limitation of the PEG ratio is how future growth is calculated. If the company uses projected growth, it may significantly different (and easier to manipulate) than if they were to use historical data.
However, these limitations make the PEG ratio no different than other ratios or metrics. Every investor needs to use more than one measurement tool to get a complete picture of a stock’s valuation. For example, looking at a company’s balance sheet over the course of several quarters can give investors a better look at trends having to do with their revenue growth or free cash flow.
The final word on the P/E growth ratio
The P/E growth ratio (or PEG) was developed and is used as a refinement of the standard P/E ratio that is used in fundamental analysis. The PEG ratio factors in a company’s forecasted growth potential either using historical data (meaning it's backward-looking) or using projected growth numbers (forward-looking). The formula for the PEG ratio is as follows:
PEG Ratio = P/E Ratio/Growth rate
Just like a P/E ratio, there is no "standard" for what constitutes a good PEG ratio. Some industries will have a "typical" PEG ratio that would seem high or low for another sector. In general, however, a P/E ratio that is around 1 is said to indicate a fair valuation for a stock. So for example, a stock that has a P/E ratio of 20 with a forecasted growth rate 20 percent would have a PEG ratio of 1.
A PEG ratio above 1 will typically indicate an overvalued stock and a PEG ratio of less than 1 will typically be an indication that a stock is undervalued.
Like any fundamental analysis ratio, the PEG has limitations, the largest being that it is only predictive of the time period being measured. For example, a company may be projecting 20% growth for the following year, but even if it achieves that growth there is no indication that it will continue to grow at that pace, nor does the PEG ratio provide a context for the growth figure. Also, the growth projections used for the PEG ratio can be determined using past growth data. While accurate in the sense that it is based on an actual, not projected, a number it can be higher or lower than the rate of growth the company is currently experiencing. Despite these limitations, the PEG ratio is still considered to be a good baseline test of valuation.