The PE vs The PEG Ratio

What is the Price-to-Earnings Ratio

The price-to-earnings (P/E ratio), involves taking a company’s current stock price and dividing it by the  earnings per share. The resulting number effectively tells you how much you can expect to put into a company to get back per Rupee of its earnings. For example, if a company’s P/E ratio is 20, you’d interpret this as investors saying they’ll pay Rs 20 per share for Re 1 of the company’s earnings. Stated differently, a stock trading at a P/E ratio of 20 is trading at 20x its annual earnings. This is called the price multiple or the earnings multiple.

Another way to look at the P/E ratio is that it tells you, given your current or desired investment, if a company had no growth and earnings stayed exactly the same, how many years it would take to recapture your current investment from the underlying profits alone.

The P/E ratio can be calculated using historical earnings, known as a trailing P/E, or forecasted earnings for a projected P/E.

The Origin of the modified PE Ratio

The origin of the PEG ratio was originally attributed to the author Mario Farina who wrote about it in his 1969 book, “A Beginner’s Guide To Successful Investing In The Stock Market.”  However, the popularity of the PEG ratio is primarily credited to Peter Lynch based on his 1989 best-selling book “One Up On Wall Street.”  However, Peter Lynch did not specifically talk about the PEG ratio as it is widely used today.  On the other hand, he did essentially describe and establish a ratio based on P/Es and growth rates.

Some stocks typically trade at a higher price to earnings ratio (P/E) than other stocks. Often this is related to the industry that they are in. As a result, it can be difficult to compare “apples to apples” when comparing the P/E for different sector groups. One method value traders use in an effort to make these comparisons is to compare a company’s P/E to its actual growth rate. This ratio is typically referred to as the Price/Earnings to Growth ratio (PEG).

The PEG Ratio

Peter Lynch developed the PEG ratio as an attempt to solve a shortcoming of the P/E ratio by factoring in the projected growth rate of future earnings. That way, if two companies are trading at 15x earnings, and one of them is growing at 3 percent but the other at 9 percent, you can identify the latter as a better bargain with a higher probability of making you a higher return. The formula for PEG is:

PEG Ratio = P/E Ratio / company’s earnings growth rate

To interpret the ratio, a result of 1 or lower says the stock’s either at par or undervalued based on its growth rate. If the ratio results in a number above 1, conventional wisdom says the stock is overvalued relative to its growth rate.

Many investors feel the PEG ratio gives a more complete picture of a company’s value than a P/E ratio. Proponents of the PEG ratio allege that it is superior to the P/E ratio as a valuation metric because the P/E ratio does not take the company’s earnings growth into consideration.

If a stock has a high PE in a high growth industry, PEG will level the playing field with a low-PE stock in a slower growth group. Please note that if a company offers dividends, the PEG Ratio does NOT take this into account and therefore renders the PEG less applicable for these companies.

The ratio is therefore often extended to being a PEGY ratio where dividend yield is also added to the growth rate in the denominator..