Price/Earnings to Growth also known as the PEG, is a type of financial ratio that is used to determine the value of a stock while taking into account the growth rate of the company’s earnings.
In other words it can be defined as a financial valuation metric that is used to determine the tradeoff between the stock, EPS and the expected company’s growth. It acts like a measure that takes future growth into account.
With the help of this metric, speculators and investors gauge whether high growth stocks are undervalued or overvalued.
How to Interpret the PEG Ratio?
The P/E ratio is high for a firm with a high growth rate, and low for a firm with a low growth rate. However, using only the price to earnings ratio will make high growth companies look overvalued as compared to other. But by dividing this ratio by the growth earnings rate, the ratio offers a better result for comparing different firms, and their growth rate.
While a low PE ratio may show that stock is a good option to buy, after factoring in the growth rate of a company to determine the stock’s price/earnings to growth ratio; it can reflect an entirely different story. The rule of thumb for interpreting PEG ratio is that, price/earnings to growth ratio below 1 is desirable. The price/earnings to growth ratio of one is said to characterize a fair tradeoff between the growth values and the cost values. It indicates that the stock is realistically valued given the growth rate expected. PEG ratio values between 0 to 1 shows that the company may offer high returns.
PEG Ratio- The Basic Formula
The formula for computing price/earnings to growth is:
The rate of growth in this formula is stated as a percentage which is divided by 100 percent. Please note to correct ratio findings for inflation it is advisable to use the real growth.
For calculation accuracy, inputs used are extremely important. For example, using historical (past) growth rates may offer inaccurate price/earnings to growth ratio if growth rates in the future are expected to diverge from previous growth rates.
To distinguish calculation methods that are used for future and historical growth, terms like trailing PEG and Forward PEG are used.
Further Reading
- The articulation of price-earnings ratios and market-to-book ratios and the evaluation of growth – www.jstor.org [PDF]
- The magic in earnings: Economic earnings versus accounting earnings – www.tandfonline.com [PDF]
- What determines price-earnings ratios? – www.tandfonline.com [PDF]
- The information content of price-earnings ratios – www.jstor.org [PDF]
- Factors affecting price earnings ratios and market values of Japanese firms – www.jstor.org [PDF]
- Fundamental determinants of the Australian price–earnings multiple – www.sciencedirect.com [PDF]
- Do price-earnings ratios drive stock values? – jpm.pm-research.com [PDF]
- Price-earnings regressions in the presence of prices leading earnings: Earnings level versus change specifications and alternative deflators – www.sciencedirect.com [PDF]
