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Understanding the PEG Ratio in Fundamental Analysis
The PEG ratio (Price/Earnings to Growth) provides more information than the P/E ratio alone
By Brian Land
Brian Land is an investment expert with over two decades of experience. He has participated in numerous appearances on CNBC, and his articles have been published in The Wall Street Journal, CNN, Daily Finance on AOL, and others. Brian is the author of the book “Trading: The Best That’s Available – Best Trading Tips for Our Time.”
Updated on March 27, 2022
The article was reviewed by Erika Rasheor
Erika Rasheor is a globally recognized expert in consumer economics, researcher, and educator. She is a financial therapist and transformational coach with a special interest in helping women learn how to invest.
Introduction
Fundamental analysis is one of the methods of gathering an understanding of the true value of a stock, based on internal and external influences. While this may sound somewhat complex, it isn’t if you know what to look for. Many ratios and tools used in fundamental analysis can be found in financial statements such as the balance sheet, income statement, and cash flow statement.
Components of the Equation
The P/E ratio is a key component of the PEG ratio. You can calculate the P/E ratio by taking the current stock price and dividing it by earnings per share (EPS). This number allows you to compare the relative value of one stock to another, as well as determine whether the market has valued a stock higher or lower compared to its earnings.
The other component is earnings growth, which refers to the relative change from period to period regarding the company’s expected earnings results.
PEG Ratio of Price/Earnings to Growth
The PEG ratio of price/earnings to growth allows you to assess a stock’s value, like the P/E ratio, while taking into account the company’s earnings growth. This expected component of the PEG ratio provides a more complete picture of a stock’s fundamentals than you would get with the P/E ratio alone.
You can calculate the PEG ratio by taking the P/E ratio and dividing it by the expected or actual earnings growth: PEG = Price to Earnings Ratio / Earnings Growth (expected or actual)
For example, if you have a stock with a P/E ratio of 2 and an expected earnings growth of 10% next year, then the PEG ratio would be 20 (P/E ratio of 2 divided by expected earnings growth rate of 10% = 20). This PEG ratio is very high, indicating that the stock is overpriced.
The lower the PEG ratio, the more likely it is that the stock is undervalued relative to earnings expectations. Conversely, the higher the number, the more likely it is that the market has overvalued the stock.
Interpreting the Results
Using the PEG ratio in conjunction with the P/E ratio for a stock can tell a completely different story than using the P/E ratio alone.
A stock with a very high P/E ratio may be considered overvalued and not a good choice. However, calculating the PEG ratio for the same stock, provided it has good growth estimates, may yield a lower number, suggesting that the stock could still be a good buy.
The opposite is also true. If you have a stock with a very low P/E ratio, you might reasonably assume it is undervalued. However, if the company does not have expectations for significantly increasing earnings, you could actually end up with a high PEG ratio, indicating that it should be avoided for purchase.
Using the PEG Ratio in Fundamental Analysis
Different
The base number for the estimated or improperly estimated PEG ratio varies from industry to industry, but the investment theory states that a PEG ratio of less than one is optimal as a general rule. When the PEG ratio equals one, this means that the expected market value of the stock is in equilibrium with the expected future earnings growth.
If a stock has a P/E ratio of 15, and the company expects its earnings to grow at a rate of 15%, for example, this gives it a PEG ratio of one.
When the PEG ratio exceeds one, this means that the market expects a higher growth than the estimates predict, or that the increased demand for the stock has caused it to be overvalued.
A ratio of less than one indicates that analysts may have set their consensus estimates too low or that the market may have misestimated the growth prospects and value of the stock.
When using other tools to conduct fundamental analysis, the PEG ratio is compared against other selected tools. If all selected tools show ratios indicating undervaluation, you may have found a stock worth investing in.
As with any analysis, the quality of the results varies depending on the input data. For example, the PEG ratio may be less accurate if calculated using historical growth rates, compared to the ratio if the company had forecasted higher or increasing future growth rates.
Source: https://www.thebalancemoney.com/fundamental-analysis-understanding-the-peg-ratio-3140796
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