What is the PEG ratio?
The PEG ratio is an investing rule of thumb that has been around for decades.
The aim is to use the price earnings growth ratio
to try to find growth at a reasonable price.
In order to calculate the PEG ratio,
we start off with calculating the P/E or price-earnings ratio.
The P/E ratio is calculated by dividing a company’s share price by an accounting metric
called earnings per share.
P/E ratios are commonly quoted and widely used.
For a company with a $50 share price, and $5 EPS, the price-earnings ratio is 10.
The price-earnings ratio shows how much investors are willing to pay per dollar of earnings.
How many years does it take to cover the price, if earnings stay the same.
Well, guess what: earnings probably won’t stay the same.
Incorporating the growth rate into the picture adds some dynamics into the fairly static
P/E ratio.
PEG takes P/E one step further.
If the company’s current EPS is $5, while it was $4 in the prior year, then they realized
an EPS growth rate of 25% over the past year.
This is what you need to calculate the price-earnings-growth ratio: take the P/E ratio that we calculated,
and divide it by the growth rate.
P/E of 10, divided by growth rate of 25, gives you a PEG ratio of 0.4.
In the PEG ratio calculation, the growth rate is adjusted from a percentage basis
to a whole number basis.
How to interpret a PEG ratio of 0.4?
For that, we need to look at the benchmark numbers for the industry that the company
is operating in.
If the average P/E ratio for the industry is 15, and the average growth rate for the
industry 15%, then the industry PEG ratio is 1 (15 divided by 15).
That would mean that a company with a PEG ratio of 0.4 would have a below average P/E
ratio with above average growth, and might be viewed as “undervalued”, worthy of
further research, and a possible buy.
The PEG ratio is a rule of thumb used for the screening of potential buy or sell candidates,
particularly among large numbers of “lesser known” stocks.
PEG ratios could drive action from investors.
Historically, some investors used the rule of thumb
to buy shares if the PEG ratio for a company was below 1,
hold shares (neither buy nor sell) if the PEG ratio was at 1,
and sell shares if the PEG ratio was significantly above 1.
With current highly inflated stock valuations, having 1 as the mid-point might be a bit on the conservative side.
If a lot of investors use the “buy if the PEG ratio is below 1” rule of thumb,
then demand for the share would go up, and as a result the share price.
A sort of automatic correction mechanism.
Let me show you how that works.
Let’s say that for the company we are looking at, the share price doubles.
Instead of the $50 it was trading at before, the share price is now $100.
As a result, the P/E ratio doubles to 20.
If the growth rate stays the same, the PEG ratio has just doubled to 0.8.
Let’s review the PEG ratio calculation in more detail.
A disclaimer is that calculating a PEG ratio is not meaningful if the earnings per share
and/or the growth rate is negative.
Other disclaimers are that the PEG ratio does not look at either dividend payouts or free
cash flow generation.
The bigger question in the PEG ratio calculation is which Earnings Per Share number to take,
and which growth rate?
For Earnings Per Share, the default choice would be the GAAP EPS number, but there are
those who would take the EPS from continued operations, or the “adjusted EPS” (excluding
any unusual items).
For both EPS and growth rate, we need to decide which time horizon we want to look at.
The latest full year “historical” EPS and growth rate?
“Rolling” EPS and growth rate, based on what is called “trailing twelve months”,
in other words the latest four quarters?
Or do we look to the future rather than the past: expected EPS and expected growth for
the next year?
Or do we go even further into the future,
by taking a 5-year average expected growth rate?
And if so, who do we trust to provide a reliable prediction of the future?
If you search for PEG ratio data on various investor websites, you will find that the
PEG ratio is not published as widely as the P/E ratio.
And if you do find PEG ratio data, you will find that different websites have applied
different ways of calculating the PEG ratio,
relating to the time horizon question we just discussed.
My advice is that if you rely on investor websites for your PEG ratio data (rather than
calculating PEG ratios yourself from source data), then pick one single website, to make
sure you at least get apples-to-apples comparable PEG ratio numbers between companies.
The PEG ratio.
Does the earnings growth justify the P/E ratio?
Use the price earnings growth ratio to find growth at a reasonable price.