Company's Financial Accounting
Price-Earnings-Growth Ratio, PEG
DEFINITION:
Price Earnings to Growth Ratio or PEG Ratio is a metric used to analyze and compare stocks with different growth rates. PEG ratio is a variation of traditional P/E ratio (Price-to-Earnings ratio) but with only the difference that it takes into account the expected growth rate in earnings per share for a specified time period. Thus, this ratio measures the value of a stock based on the relationship between stock's price, earnings per share (EPS) it will generate, and the expected company's growth rate.
PEG Ratio, as well as traditional P/E ratio, is a financial metric used to determine a stock's value, and to evaluate whether a stock is undervalued or overvalued. This is more accurate valuation measure than the standard P/E ratio.
FORMULAS for calculations:
PEG = PE ratio / Expected Growth Rate in Earnings
PEG = Share Price / Earnings per share / Expected Earnings per Share (EPS) growth rate
PEG Ratio (gurufocus) = PE Ratio without NRI / 5-Year EBITDA Growth Rate
Where,
- PE Ratio without NRI - Price-to-Earnings ratio without non-recurring items
- EBITDA - earnings before interest, tax, depreciation and amortization
- The denominator is a percentage; however, it is used the whole number instead of the decimal form for the calculation (a growth rate of 15% would be in the denominator as 15).
KEY POINTS. PEG Ratio:
- measures the true stock valuation.
- evaluates an investment risk.
- helps investors to find stocks that are likely to increase in value in the future.
- helps investors to compare stocks that are growing at different rates.
- builds on the P/E ratio, taking into account not just current earnings but also its expected growth. Thus, ratio takes into accounts the future growth of the company.
- it is thought to provide a more accurate picture of a stock's true value than the standard P/E ratio.
- term "forward PEG" means that expected future growth is used in calculations.
- term "trailing PEG" means that historical growth is used in calculations. Past earnings data can be found from the company’s financial statements. However, they are not reflecting the company’s future prospects as future growth may slow or quicken.
- thus, it should be noted that the company's growth rate is an estimate as future growth can change due to a lot of different factors. Ratio does not take into account the overall growth rate of the economy, as a result the ratio should to be compared to average PEG's across its industry and the entire economy.
- meaningless for the companies with negative earnings or negative projected growth.
- can be calculated using 1, 3 or 5-year expected growth rates.
- should be considered only as one of the many factors when valuing a business.
RESULT INTERPRETATION:
- similar to traditional P/E ratio, the lower the PEG ratio the more the stock may be undervalued.
- lower PEG is a better indicator to buy.
- the result interpretation that indicates an overvalued or undervalued stock varies by industry and by company type.
- stocks should be compared within the same industry, company’s industry peer group.
- PEG ratio = 1, i.e., a company's P/E is equal to expected growth:
- fairly valued company given the expected growth;
- states that the business is fairly priced or valuated;
- the market value and earnings growth of the company have a perfect connection.
- PEG < 1
- considered as better ratio;
- denotes an undervalued or fairly priced company;
- the sign that market has underestimated the stock's growth prospects and value;
- the stock market analysts have set their estimates too low.
- PEG > 1
- means an overvalued company;
- considered as unfavourable;
- sign that the market expects more growth than fundamental estimates predict;
- increased demand for a stock has caused it to be priced too high.
- negative PEG; PEG < 0
- means that company is losing money or expecting to have negative growth (negative earnings or negative growth);
- this is an indicator of high investment risk.
EXAMPLE 1
Assume there are two hypothetical companies: A and B
Company A:
- Share Price = $32
- EPS current year = $3,02
- EPS previous year = $2,74
- EPS growth = ((EPS final - EPS initial) / EPS initial) * 100%
- EPS growth = ((EPS current year / EPS previous year) - 1) * 100%
- P/E ratio = $32 / $3,02 = 10,6
- Earnings growth rate = ($3,02 / $2,74) - 1 = 10%
- PEG ratio = 10,6 / 10 = 1,06
Company B:
- Share Price= $68
- EPS current year = $3.58
- EPS previous year = $2.76
- P/E ratio = $68 / $3,58 = 19
- Earnings growth rate = ($3,58 / $2,76) - 1 = 30%
- PEG ratio = 19 / 30 = 0,63
Company A seems more attractive since it has a lower P/E ratio. Nevertheless, company B has more higher growth rate and its PЕG ratio is less than 1 that denotes an undervalued company. Company B is more preferable to buy as it has lower PEG ratio than company A; and company B is trading for a discount compared to its value.
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