PEG Ratio

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The PEG ratio (price-earnings to growth) is a valuation metric that describes the relationship between the price of a stock, the earnings generated per share and the growth rate. It is obtained by dividing the price per earnings of a company with its growth rate. Generally, a company with a high growth rate will have a higher price to earnings ratio. Using only the price to earnings ratio to compare two different companies will make the company with a higher growth rate to appear overvalued.

When the price to earnings ratio is divided by the growth rate of the company, the resulting ratio, which is called the price-earnings to growth ratio is a normalized ratio that can be healthily used to compare two different companies with different growth rates.

The price-earnings to growth ratio was originally developed by Mario Farina, who described it in his 1969 book titled “A Beginners Guide To Successful Investment In The Stock Market”. Peter Lynch also wrote about price-earnings to growth ratio in his 1986 book titled “One Up On Wall Street”.  According to both authors, the price to earnings ratio of a fairly priced company will equal its growth rate.

PEG Ratio Formula

PEG = \dfrac{\text{P/E Ratio}}{\text{Annual Earnings per Share Growth Rate}}

The price-earnings to growth ratio is calculated by dividing the price per share with the earnings per share (this is the P/E ratio) and dividing the result by the annual earnings per share growth which is expressed in percentage. The earnings per share growth must be in percentage when dividing. The growth rate should also be real, to avoid inflation.

The growth rate and other information about a company can be found on financial websites like Yahoo! Finance, NASDAQ. Yahoo! Finance uses a 5-year expected growth rate and a Price/Earnings based on the earnings per share estimate for the current fiscal year for calculating price-earnings to growth.

The formula is used to estimate whether a stock is good for investment. It is favored over the price to earnings ratio because is it accounts for growth. Price-earnings to growth of 1 is said to be a fairly valued stock, while one below 1 is said to be undervalued. Undervalued stocks are expected to provide higher returns.

PEG Ratio Example

Blue is a company with a price per share of $55. They have an earnings per share of $3.5 with a previous year’s earnings per share of $2.8.

Meanwhile, Yellow is a company that has a price per share of $79 with earnings per share of $3.9. Their previous year’s earnings per share were $2.7. They have earnings per share growth of 44%. Let’s calculate and compare the two companies using their price-earnings to growth.

For company Blue the data includes the following:

  • Price per share = $55
  • Earnings per share = $3.5

To calculate the earnings per share growth, we subtract the previous year’s earnings per share ($2.8) from the current ($3.5) and divide the answer by the previous year’s earnings per share. This number represents the percentage of the previous earnings per share by which the current earnings per share has grown.

So the earnings per share growth is 0.25. We convert the earnings per share growth to a percentage by multiplying by 100%

  • Earnings per share growth = 25%.

Now we can use our formula to calculate the PEG ratio:

PEG = \dfrac{55/3.5}{25} = 0.63

The price-earnings to growth ratio of company Blue is 0.63.

For company yellow, the data includes the following:

  • Price per share = $79
  • Earnings per share = $3.9
  • Earnings per share growth = 44%.
  • We can now calculate the PEG again.
  • Price-earnings to growth = ($79 / $3.9) / 44%
PEG = \dfrac{79/3.9}{44} = 0.46

Company Yellow has a PEG ratio of 0.46.

The price-earnings to growth ratio of company Blue is 0.63 while Yellow is 0.46. Again, the lower the price-earnings to growth, the more undervalued the stock is. Comparing them, Yellow is cheaper to invest in despite the higher stock price because of its growth rate.

If only price to earnings per share was considered, we wouldn’t have an accurate comparison. Company Blue has a cheaper price to earnings per share ratio, of 15.7, while company Yellow has 20.25.

PEG Ratio Analysis

The PEG ratio is used to determine a stock’s value while also factoring in the company’s growth rate. Low price-earnings to growth ratio means that a stock is undervalued and may be worth investing in. High price-earnings to growth ratio means otherwise.

The use of price to earnings per share (P/E) may make a stock look favourable to investors without considering the growth rate of the company involved. However, with the Price earnings to growth ratio, the growth rate is factored in; and the lower the PEG ratio, the more undervalued the stock is given its future earnings expectations.

It should also be noted that the degree to which the price-earnings to growth ratio may indicate the valuation of stock also depends on the type of company or industry. However, as a general rule, price-earnings to growth of less than 1 is considered desirable. The price to earnings ratio may also vary depending on the growth forecast – whether a one-year growth or five-year forecast is used.

A major disadvantage of price-earnings to growth ratio is that price-earnings to growth ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.

PEG Ratio Conclusion

  • The price-earnings to growth is a valuation metric that describes the true value of a stock.
  • The lower the PEG ratio, the desirable the stock.
  • The PEG for one company may differ depending on the source and method of forecasting for the company’s growth.
  • PEG is calculated by dividing the price to earnings per share ratio by the earnings per share growth forecast.

PEG Ratio Calculator

You can use the PEG ratio calculator below to quickly calculate a company’s stock’s true value by entering the required numbers.