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What is the PEG ratio?

The Price/Earnings-to-Growth (PEG) ratio goes a step ahead of the P/E ratio,dividing the P/E ratio by the growth rate of its earnings for a specified period.The PEG ratio draws a relationship between the P/E ratio and the projected earnings growth rate over a specified period, say 1 year, 2 years or 3 years, and hence provide a more informed view of the stock.

How to calculate the PEG ratio?

PEG Ratio =

Price/EPS
-------​-------
EPS Growth

The components of the PEG ratio formula are​

- Market Price of stock​

- Earnings per share (EPS) = Total earnings/ Number of shares

- EPS Growth = Projected growth available on financial websites or {(EPS of this year/EPS of last year)-1}

For example

Consider the following details of Growth Ltd for FY 21-22:

Earnings = Rs.10 lakh

Price = Rs 12 per share

Number of shares = 2 lakh

EPS growth last year was 2%

Projected EPS = 3%.

EPS = (10,00,000/2,00,000) = Rs. 5​

P/E ratio is 12/5 = 2.4

The PEG ratio is 2.4/3 = 0.8

In the same example, if the EPS for this year, say Rs 5 and last year, say Rs 4.5, were given, then that can be used to derive the EPS growth percentage by using the formula {(EPS of this year / EPS of Previous year)-1} = {(5/4.5)-1} = 11%

What does this ratio mean?

Experts believe a PEG ratio equal to 1.0 denotes a fairly valued stock. A ratio below 1.0 is an undervalued stock and above 1.0 indicates an overvalued stock. So in the above example, the stock is undervalued compared to its expected growth, and the investors are paying less per unit of earnings growth. To what extent it is undervalued must be measured based on the industry, company type, etc.

Pros and Cons of the PEG ratio

The PEG ratio is a forward-looking metric and considers the stock’s expected profits rather than past performance. PEG ratio factors in the company’s growth rate compared to the P/E ratio, which requires a separate analysis by investors to factor in the company’s growth. For a complete analysis, the ratio must be analysed with financial reports.

The only challenge with the PEG ratio is that growth rates aren’t always accurate or easily available. The PEG ratio considers the EPS growth rate based on a certain number of years. Since this could vary, PEG ratios cannot be used for comparison as the growth rates will differ. Also, earnings forecasts tend to be less accurate when spread over a longer period.

Comparison of PEG ratio and P/E ratio

The major factors of distinction between the P/E ratio and the PEG ratio are as follows:

Particulars

P/E ratio

PEG Ratio

Components

Price and Earning per Share

Price, Earnings per share and EPS growth

Popularity

More Popular and widely used

Lesser known

Types

There are two types of P/E ratios - trailing and forward

There is only one type of PEG ratio

Interpretation

The higher the P/E ratio, the more the market is ready to pay for Re. 1 of its earnings.

The PEG ratio must be 1, which denotes equilibrium, so the stock is neither undervalued nor overvalued.

Both ratios aid in the fundamental analysis of stocks and help make sound financial decisions. However, they must not be used in isolation for making an informed decision regarding the stock’s value.

Frequently Asked Questions (FAQs)

What Is considered to be a good PEG Ratio?

A PEG ratio of 1 indicates equilibrium, meaning that the earning potential and perceived value of a stock's worth are in sync.

What Is Better: A Higher or Lower PEG Ratio?

A higher PEG ratio means that the markets have overvalued the stock, and a low PEG ratio means that the stock has been undervalued. Hence, a lower PEG ratio is better as the stock may have more potential than perceived.

What Does a Negative PEG Ratio indicate?

A negative PEG ratio indicates that the stock’s present income is negative or that future earnings are expected to drop, indicating a negative growth pattern.

What does a PEG ratio of 2 mean?

A PEG ratio higher than 1 denotes the overvaluation of the stock and is not considered favourable. So a stock with a PEG ratio of 2 is definitely overvalued.

What is the P/E ratio vs PEG?

The P/E ratio generally indicates a stock’s past performance and does not consider the growth potential of the stock. The PEG ratio considers the stock’s growth potential andcould be useful in financial decision-making.

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