PEG Ratio (Price/Earnings-to-Growth): Meaning & Formula

The PEG ratio is a valuation metric that improves on the P/E ratio by incorporating the growth rate of a company’s earnings over a certain period. While factoring in the growth, this ratio provides a better and clearer picture of the performance of a company.

Thus, in turn, this ratio helps you as an investor estimate whether a certain stock is overvalued or undervalued, so that you can make an informed investment decision.

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What Does the PEG Ratio Mean?

The ratio for PEG takes a step beyond the P/E ratio (price-to-earnings ratio) and divides it by the rate of growth of a company’s earnings over a specific period. The aim here is to draw a relationship between the projected growth rate of a company’s earnings and its P/E ratio for that set period.

This set period or time frame can be for say 1, 2 or 3 years. This provides an informed view of a stock that you are analysing before investing. To arrive at this ratio, you must employ a simple formula and obtain a numerical figure.

Upon employing the applicable formula, if you arrive at a lower PEG value, it is generally an indication that a stock is going undervalued compared to its growth rate, signalling investment potential. While you arrive at a ratio much higher, it is a typical indication that a stock is overvalued relative to its growth potential.

PEG Ratio Formula and Calculation

Now that you know the  PEG ratio meaning, you must note the applicable formula to arrive at the respective PEG value of a stock.  The applicable formula for this  ratio is as follows:

PEG ratio = (P/E ratio) / (Earnings growth rate)

Hoover, here, first you must know how to arrive at the P/E ratio relative to a certain stock. Here, you must use the respective P/E formula, i.e. current share prices/earnings per share. The P/E ratio here reflects an insight into how much investors are ready to pay more for each rupee they earn.

The earning growth rate is the expected annual rate of growth in a specified time (e.g. 1 year) in the form of a percentage.

You can arrive at the EPS growth rate by subtracting the previous year’s EPS from the current year’s EPS and dividing it by the previous year’s EPS. Then multiply it by 100 to arrive at a percentage.

Now, feeding this information to the PEG formula, you will arrive at the ratio.

Calculation Example for PEG Ratio

To understand what is PEG ratio is and its calculation with more clarity, let us use a reference example:

Suppose the company stock you are exploring has a P/E ratio of 20. Its annual anticipated EPS growth rate is 15%. Now, if you feed this information into the formula, we arrive at:

Ratio of PEG = (20/15) = 1.33.

From the above calculation, it is clear that if you invest in this stock, you might have to pay 1.33 times the anticipated growth rate of the respective company for each rupee you earn from it.

However, as a benchmark, investors consider a PEG of 1 as a fairly valued stock. Comparing this benchmark with the result, this exemplary stock is slightly overvalued.

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How to Interpret the PEG Ratio?

Now that you know how to calculate the PEG value or ratio of a stock, you must know how to interpret it for a detailed analysis and comparison. Here is a step-by-step guide:

Step 1: Suppose you are comparing two company stocks. One has a P/E ratio of 20, and the other has a P/E of 25.

Step 2: You must consider their EPS growth rate. Imagine the stock with a P/E of 20 has an EPS growth rate of 15%. The other one has a growth rate of 27%.

Step 3: Now you use the formula and arrive at a PEG value of 1.33 for the stock with a P/E of 20. For the latter, the same ratio is 0.92.

Step 4: Thus, the stock with a PEG of 1.33 means it is slightly overvalued. While the latter stock has its PEG below 1, investors typically consider it an undervalued stock, i.e. trading at a discount when taking its future growth into account.

What is a Good PEG of a Stock?

As per the experts, a PEG value of 1 for a stock is good, as it implies that the stock is fairly valued. A PEG over 1 is typically an overvalued stock. While a stock with a PEG below 1 is typically undervalued.

However, while interpreting and comparing stocks, you must bear in mind that the PEG value might vary between industries and thus, inferences must be in the industry context, type of companies, etc.         

What Does a Negative PEG Mean in a Stock?

While analysing stocks before investing, if you arrive at one with a negative PEG value, it means that its growth rate of earnings is negative. It typically happens because of a few reasons. They include declining earnings, meaning the respective company is making losses.

Also, an irregular pattern of company earnings may result in a negative earnings growth, hence, a negative PEG. Such companies are usually not financially stable and may have cash flow issues.

Differences Between PEG Ratio vs P/E Ratio

Advantages and Limitations of the Price/Earnings-to-Growth ratio

Before you use this ratio for comparing stocks, you must note some of its advantages and disadvantages for an informed use of it:

• Advantages of the PEG Ratio

• Comprehensive Analysis

Alongside using the P/E ratio, a PEG helps investors to get a complete picture of a stock. It helps you as an investor to understand whether a higher P/E is justified by a strong growth in the company’s earnings.          

• Making Decisions

As with PEG values equal to, beyond or below 1 representing a fair valuation, overvaluation and undervaluation, it makes investment decisions easier for investors.    

• Disadvantages of the PEG in Investments

• Dependency on Growth Projection

The accuracy of PEG depends on the earnings growth projection. However, at times this projection might be uncertain and is subject to changes.

• Unsuitable for All Sectors

This ratio may not be efficient in industries where earnings growth is uncertain. For example, in cyclical industries, startups, etc, this ratio might not be effective.

When Should Investors Use the PEG Ratio?

When earning growth is a key factor while evaluating stocks, this ratio becomes useful. You can use it while assessing stocks with a higher P/E ratio, and you need assurance that future earnings growth is there.

You can also use it to compare company stocks in the same sector and between companies with a varied rate of earnings growth. If you are an investor with a medium to long-term perspective, this ratio might seem useful for you.       

Conclusion

PEG ratio is an effective evaluation tool, especially for stocks, to understand the balance between its price and its growth prospects. You can arrive at it using a simple formula and decide whether a stock price is fair, overvalued or undervalued.        

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Frequently Asked Questions (FAQs)

1. What is the PEG ratio formula?

The formula for the ratio of PEG is (P/E ratio) / (Earnings growth rate).​

2. Is a higher or lower PEG value better?

A lower PEG is generally better, and a PEG below 1 indicates an undervalued stock. A PEG around 1 means it is fairly valued, and above 1, it suggests that it is overvalued relative to its earnings growth.

3. What does a PEG value or ratio of 1 mean?

A PEG value of 1 indicates that a stock is fair in terms of its valuation compared to its earnings growth rate.

4. Where can I find the PEG value or ratio of a stock?

Generally, you can locate a PEG of company stocks on stock market portals or from your broker’s portal while investing.