PEG ratio isn’t the mysterious focal point of the 70s American rock band Steely Dan (“Peg,” the 1977 hit from Steely Dan), but what it is, how it works and when you use it is a mystery to some potential investors.
This article explains the price-to-earnings-to-growth (PEG) ratio.
What is a PEG Ratio?
The PEG ratio is a metric investors use to determine the value of a stock. It compares a company’s price-to-earnings ratio to its expected growth rate.
These metrics help an investor evaluate a company’s stock. A PEG ratio is considered to be the one metric that levels the playing field among growth and value companies, unveiling a stock’s true value.
Investors can use the PEG ratio to determine the trade-off between a company’s stock price, earnings per share and future potential growth.
Understanding the Components of the PEG Ratio
It’s important to understand the parts that make up a PEG ratio, starting with the price-to-earnings (PE) ratio. The PE ratio helps you look at a company’s current stock price based on the company’s past earnings. But that doesn’t help you going forward.
High earnings in a company’s past don’t mean the company will have the same earnings growth rate or higher in the future.
The expected rate of growth that plugs into the formula to give you the PEG ratio is an estimate based on past growth or the consensus for the current year, neither of which imbues certainty in the process.
Calculating the PEG Ratio
Stock valuation can be complex, but calculating the PEG Ratio is straightforward as long as you have the numbers.
You divide a company’s PE ratio by the expected growth rate of a company. Say a company has a PE of 10, and its expected growth rate is 10%. The simple math gives you a PEG ratio of 1 because 10/10 = 1.
However, the complexity comes with getting the numbers you need to calculate.
Investors need three numbers to calculate the PEG ratio: the stock price, the earnings per share and the expected growth rate.
You can find the current market price of a stock with no problem. But then, you have to estimate the earnings per share and the growth, which can raise the level of uncertainty in the numbers.
Some investors will use a company’s previous year’s earnings instead of an estimate. However, past results aren’t necessarily indicative of future earnings. Using the consensus earnings estimate for the company’s present year also has its downside: it’s still an estimate, not a known value.
Still, both methods can get you to an earnings per share to use to calculate the PEG ratio.
As with earnings, trying to estimate a company’s future growth is just as difficult. You can rely on historical growth, but you have no assurance the company will continue to grow at that pace. The growth may slow or it may pick up.
Interpreting the PEG Ratio
A good PEG ratio is 1 or lower. If a stock has a PEG ratio higher than 1, then the stock is overvalued. A lower PEG ratio could indicate you may get a good deal on a stock.
For instance, if you have a stock with a PEG ratio of 0.06, that is an opportunity to buy because it could be undervalued compared to its potential growth rate, and you may see a good return.
Advantages and Limitations of the PEG Ratio
The PEG ratio has three advantages over other valuations. For investors, the PEG ratio provides a truer valuation of a company’s stock than the price-to-earnings ratio by itself. The PEG ratio factors in the expected rate of growth, giving an investor an idea of the potential growth of the company.
If a company has a high PE, that ratio might not hold up when compared to the expected growth of the company.
The PEG ratio helps level out certain factors that usually make it difficult to compare one company to another. However, the PEG ratio allows you to compare the relative valuations of companies across a sector.
PEG Ratio Limitations
With its advantages and wide use, the PEG ratio still has several limitations:
- There is no linear relationship between the price-to-earnings ratio and the rate of growth, but the setup of the PEG ratio assumes a linear relationship.
- Differences like dividends, the duration of growth of a company and risk aren’t factored into the process either.
- The PEG ratio does not take into account variations in growth.
Even with the PEG ratio, investors still should have other analyses to complete, including leadership and financial statements.
Comparing the PEG Ratio With Other Valuation Ratios
The goal of valuation is to see how appropriately a company’s stock is valued. Is it overvalued or undervalued? Well-known investor Peter Lynch considers the PEG ratio to provide a clearer picture of a stock’s value since a good PEG ratio of 1 shows that a PE and expected growth are equal, denoting a fairly valued stock.
Here are a few of the other valuation ratios.
Price-to-Earnings Ratio
This is the market price of a stock compared to its earnings per share.
Price-to-Book
This is what the company would be worth if it were sold off in parts.
Dividend Yield
This is taking the annual dividend of a stock, if it has one, and dividing it by the market price of the stock.
Price to Sales
This is where you compare the market price of a stock to its sales per share.
Each of the valuation methods has advantages and disadvantages, but these are ratios used the most by investors.
Tips and Strategies for Using the PEG Ratio Effectively
Using the PEG ratio accurately can help you pick your stocks. Here are some tips to know when to use PEG ratio or use a different valuation method.
U.S. News & World Report says the PEG ratio should only be used on profitable companies. Some unprofitable companies can deliver a profit later. If you use the PEG ratio on unprofitable companies, the negative ratio might cause you to pass on the company.
Using the PEG ratio should be used with other methods of evaluating companies, such as reviewing a company’s financial statement. The purpose of the PEG ratio is to see how a company’s stock might perform in the future.
Accounting for the growth of companies that have limited earnings, you might find those companies’ stocks more valuable.
Another tip is not to rely on the PEG ratio alone. While it can help you compare which company stocks will deliver the best return on investment, you should have other methods of evaluating a company’s stock price, too.
Also, understand your risk tolerance. Are you looking for growth companies, which generate significant cash flows and earnings at a faster rate than their peers, or value companies, which typically are larger and less volatile?
Use the PEG Ratio as Just One Tool in Your Kit
While the PEG ratio improves your view of the true value of stock over the PE ratio, it still should just be one way of several that you use to evaluate which company stocks to buy. It can provide you with better insight into which company is more likely to provide the higher return on investment you want.
Frequently Asked Questions
What P/E ratio is good?
Whether a P/E ratio is good or bad depends on what you’re comparing it to and whether you’re a value or growth investor. However, generally, the lower the P/E ratio, the better.
What is a good PEG ratio for a stock?
A PEG ratio of 1 or lower is generally considered good because it indicates a stock is undervalued.
Can a PEG ratio be negative?
Yes. A negative PEG ratio usually indicates a company is losing money or is not growing.
About Sarah Edwards
Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.