Definition and Example of PEG Ratio
The Price/Earnings to Growth (PEG) ratio is an enhanced version of the Price/Earnings (P/E) ratio. Both are common methods for comparing two stocks and measuring their relative valuation.
How to Calculate the PEG Ratio
To calculate the PEG ratio for a specific stock, you must divide the P/E ratio by the earnings growth rate of the stock. This formula can help identify stocks that are undervalued (or avoid stocks that are overvalued relative to their worth).
How the PEG Ratio Works
Using the PEG ratio along with the P/E ratio for a stock can tell a completely different story than using the P/E ratio alone. For example, suppose you have a stock with a high P/E ratio, which people might consider overvalued and not a good investment. If this stock has good growth estimates, and you calculate the PEG ratio, you might get a lower number, indicating that the stock may still be a good investment.
What is a Good PEG Ratio?
The benchmark for a safe or even great PEG ratio varies from industry to industry, but as a general rule, a PEG of less than 1 is best. When the PEG ratio is exactly 1, the market’s expected value for the stock is balanced with what you can expect from future earnings growth.
Limitations of the PEG Ratio
The biggest risk in using the PEG ratio to find cheap stocks comes from being tied to overly high hopes. Remember that growth estimates are just that; they are not definitively backed by promise. Using a more conservative number you can arrive at can help avoid paying too much for a stock that does not grow as you expect.
Dividend-Adjusted PEG Ratio
The simple PEG ratio works best for stocks that do not pay dividends. However, there are many stocks that do pay dividends, such as major companies and blue-chip stocks. Those dividends affect the company’s actual net earnings, influencing the entire formula. But there is a way to address this factor. If the stock you are watching pays dividends, you may prefer to use the dividend-adjusted PEG ratio. To obtain this number, you should slightly adjust the standard PEG ratio. Instead of simply dividing P/E by the expected earnings growth, you should first add the expected earnings growth to the dividend yield. Then divide P/E by this result.
Source: https://www.thebalancemoney.com/using-the-peg-ratio-to-find-hidden-stock-gems-357497
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