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PEG Ratio: Definition, Calculation and Usage 

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The PEG ratio is a key metric used in fundamental stock analysis for evaluating a stock’s valuation. It compares a stock’s price-to-earnings (P/E) ratio with the company’s expected earnings growth rate. A PEG ratio significantly above 1 may suggest that the stock is overvalued, indicating its price might not align with projected company performance. On the other hand, a PEG ratio significantly below 1 can indicate an undervalued stock, one where the current price might not fully capture future growth expectations.

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What Is the PEG Ratio?

“PEG” stands for price-earnings-to-growth. The price-earnings-to-growth ratio is calculated according to the following formula:

  • PEG = (price-to-earnings ratio) / (expected earnings growth rate)

The price-to-earnings ratio, or P/E ratio, is one of the most important measures of a stock’s performance. It compares a stock’s price against the earnings of the underlying company. This helps investors to determine whether that price is based on the company’s actual financial position, or if it’s based on hype, demand or other market forces unrelated to business performance.

This can help investors avoid buying stocks that are inflated past the company’s actual value and are likely to decline in value. It can also help them find stocks that the market has overlooked and, as a result, may appreciate in value once investors realize the strength of the underlying asset.

This is particularly useful for long-term investors and those seeking dividends, as both forms of trading rely on the actual or intrinsic value of the underlying company. The PEG ratio takes this analysis a step further.

Through the PEG ratio, investors compare a stock’s P/E ratio against the expected earnings growth rate of the underlying company. While the P/E ratio allows investors to decide whether a stock has been historically priced accurately, the PEG ratio helps them to decide whether the stock is a good buy for prospective value. It compares the current value of the stock against how that company is expected to perform, allowing investors to decide whether the stock is worth buying.

How to Use the PEG Ratio

An investor uses the PEG ratio to determine which stocks to buy.

There are two primary uses for the PEG ratio.

The first is to create an additional basis for comparison among companies. A P/E ratio can help investors understand stock prices in the context of a company’s historic earnings. The PEG informs investment on a forward-looking basis. Investors can determine whether a company is well-priced based on how it will perform in the future. A company with relatively limited earnings might in fact be a strong investment once growth is also taken into account.

By contrast, a high-earning company might not be poised for much growth. Despite a strong P/E ratio, in this case, investors probably wouldn’t see much return on an expensive stock that doesn’t change very much.

A PEG ratio can also help investors tell whether a stock has been overvalued or undervalued. A ratio significantly above 1.0 indicates that the stock might be too expensive for its likely growth. So you could spend a lot of money, but might not see much in return. A ratio much below 1.0 can indicate that the stock is poised for real growth, with its price too low for the company’s likely performance.

An Example of How to Use the PEG Ratio

Suppose that ABC Corp. has a PE ratio of 20, calculated by comparing ABC Corp.’s stock price against its total earnings per share. The company’s earnings are expected to grow at a rate of 14%.

As a result, ABC Corp.’s PEG ratio would be:

  • PEG = (price-to-earnings ratio) / (projected earnings growth)
  • PEG = 20 / 14
  • PEG = 1.42

In this example, ABC shares may be more expensive than the company’s expected growth warrants.

Limitations of the PEG Ratio and Other Considerations

The most important limitation of the PEG ratio is that it’s based on what is ultimately an unknown value. Growth projections for a company aren’t speculative. They’re based on a significant number of factors that arise from the underlying business. Yet, while a company’s anticipated growth is not arbitrary, it also isn’t set in stone. This is a prediction. It’s only as reliable as the underlying data, and sometimes not even then.

A PEG ratio estimates an important element of investing, how likely it is that the company will gain value over time. But despite the appearance of precision given by the PEG formula, it is still based on an uncertain value.

Frequently Asked Questions (FAQs) for the PEG Ratio

What Is a “Good” PEG Ratio?

A PEG ratio below 1.0 is generally considered favorable, as it often indicates a stock may be undervalued relative to its growth potential. A PEG ratio above 1.0 is typically seen as less favorable, suggesting the stock may be overvalued.

Is a Higher or Lower PEG Ratio Better?

A lower PEG ratio is generally considered better because it suggests that a stock is undervalued relative to its earnings growth. A lower PEG ratio (<1) suggests that investors are not overpaying for future growth.

What Does a Negative PEG Ratio Mean?

A negative PEG ratio usually stems from negative earnings or an anticipated decline in growth, which may signal financial challenges for the company. Possible reasons for a negative PEG ratio include declining earnings growth, a negative P/E ratio or a temporary setback with lower recent earnings.

Bottom Line

Financial advisor discusses the PEG ratio in the context of a portfolio with her clients.

The PEG ratio evaluates a company’s stock price in relation to its expected earnings growth. This form of fundamental analysis allows investors to consider not only a company’s past performance but also its anticipated future growth, giving a more comprehensive view of potential investment value. By incorporating growth expectations, the PEG ratio offers insights that can help investors make more informed decisions about a stock’s true potential.

Tips for Analyzing Stocks

  • A financial advisor can use the PEG ratio and other methods of advanced analysis to choose investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goalsget started now.
  • Besides the PEG ratio and P/E ratio, there are several other key metrics that investors use to assess potential opportunities. One is the price-to-sales ratio; another is the price-to-dividend ratio.

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