A PEG ratio is a tool used in fundamental stock analysis by investors to assess a share’s value. It measures a stock’s price-to-earnings ratio against the anticipated earnings growth for the underlying company. If the ratio is significantly above 1, the stock might be overvalued; its price might not accurately reflect how the company is expected to perform. If the ratio is significantly below 1, the stock might be undervalued; its price might not accurately reflect future expectations.
PEG Ratio, Defined
“PEG” stands for price-earnings-to-growth. The price-earnings-to-growth ratio is calculated through the basic formula:
- PEG = (price-to-earnings ratio) / (expected earnings growth rate)
The price-to-earnings ratio, or PE 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 is based on hype, demand or other market forces unrelated to business performance.
This can help investors to avoid buying stocks that have gotten inflated past the company’s actual value and are likely to decline in value. It can also help them to find stocks that the market has overlooked, and which as a result may grow 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 particularly on the actual value of the underlying company.
The PEG ratio takes this analysis an extra step.
Through the PEG ratio, investors compare a stock’s PE ratio against the expected earnings growth rate of the underlying company. While the PE 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
There are two primary uses for a PEG ratio. The first is to create an additional basis for comparison among companies. A PE 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 with growth taken into account.
By contrast, a high-earning company might not actually be poised for much growth. Despite a strong PE ratio, in this case, investors probably wouldn’t actually see much return on an expensive stock that doesn’t actually 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. You’ll spend a lot of money but probably won’t see much 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.
A Sample 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 percent.
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
The most important limitation of the PEG ratio is that it is based on what is ultimately an unknown value.
Growth projections for a company are not speculative. They are based on a significant number of factors that arise from the underlying business. Yet, while a company’s anticipated growth is not arbitrary, it is also not set in stone. This is a prediction. It is 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.
The Bottom Line
The PEG ratio measures the ratio of a company’s price-earnings to anticipated growth. It is a form of fundamental analysis that lets investors choose stocks based not only on a company’s historic earnings but also its expected earnings.
Tips for Analyzing Stocks
- A financial advisor can use 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 up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Besides the PEG ratio and PE 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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