Price to Earnings to Growth Ratio: PEG
The Price to Earnings Ratio is one of the most popular ways to evaluate a stock is based on earnings, because we calculate by taking the current price of the stock, and divide it by the Earnings per Share (EPS). This will determine whether a stock's price is more or less expensive compared to its earnings. This will result in one of two conclusions by investors.Scenario 1:
"A company with a high P/E is overpriced, therefore, I should not buy it at this time"
Scenario 2:
"A company with a high P/E probably means that investors have pushed a stock's priced beyond the point where high growth was possible"
Scenario 3:
"A company with a high P/E may also mean that a company has a lot of confidence that it will have strong growth prospects in the future, which should be mean I should be well off with this stock"
All three of these scenarios could be true based on a high P/E score. But another way to look at future earnings growth is by using the PEG ratio.
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There are many different ways to analyze a company's worth. One of them is through the Price to Earnings to Growth Ratio, by taking the P/E and dividing it by the projected growth in earnings.
PEG = PE / (projected growth in earnings)
For example, stock with a P/E of 40 and projected earning growth of 15%, which means that they have a PEG of 2.67.
What does the 2.67 stand for? A ratio is simply a relationship between two objects. In this instance, the lower the PEG, the less you have to pay for each unit of Future Earnings Growth. This means that even if a stock has a high P/E, the high projected earning growth may suggest other wise. On the contrary, a low PE stock with low/ no PEG would not be a smart choice to make. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8.
The PEG ratio that indicates an over or underpriced stock varies by industry and by company type, though a broad rule of thumb is that a PEG ratio below one is desirable. Also, the accuracy of the PEG ratio depends on the inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. To distinguish between calculation methods using future growth and historical growth, the terms "forward PEG" and "trailing PEG" are sometimes used.
PEG ratio results greater than one suggests
Scenario 1
Market expectation of growth is higher than consensus estimates.
Scenario 2
Stock is currently overvalued due to heightened demand for shares
PEG ratio results of less than one suggests
Scenario 1
Markets are underestimating growth and the stock is undervalued.
Scenario 2
Analysts believe that estimates are currently set too low. (good)
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Examples
Calculate the PEG
Lets take an imaginary company named ABC Industries. Lets say that ABC Industries has a PE of 20 times earnings. If the anticipated earnings growth of 12% over the next five years.
20 (x times earnings)/ 12 (n % anticipated earnings growth) = 1.66
There is another Rival company named XYZ Industries. It is a company with a PE of thirty times earnings. The Company has a anticipated earnings growth of 40 percent, over the next five yeras.
30 (x times earnings) / 40 (n % anticipated earnings) = .75
Interpreting the PEG
Using ABC and XYZ industries as examples, the PEG ratio actually points out that ABC Industries stock price is higher than its earning growth. This means that if the company's growth rate does not increase, the stock price will decrease. XYZ's PEG ratio of 3/4 points out that the stock is undervalued, which means that the stock price will increase.
Stock theory suggests that the stock market should assign a PEG ratio of one to every stock. This would represent theoretical equilibrium between the market value of a stock and anticipated earnings growth. For example, a stock with an earnings multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of one.
A great feature of the PEG ratio is that by bringing future growth expectations into the mix, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This makes it easier to compare different industries, which tend to each have their own historical P/E ranges. Lets look at an example of comparing Company A and Company B.
-Five-year projected growth rate: 25% -PEG: 35/25, or 1.40 | Company B-Current P/E: 16 times earnings -Five-year projected growth rate: 15% -PEG: 16/15, or 1.07 |
Even though these two fictional companies have very different valuations and growth rates, the PEG ratio allows us to make an apples-to-apples comparison of the relative valuations. What is meant by relative valuation? It is a mathematical way of asking whether a specific stock or a broad industry is more or less expensive than a broad market index, such as the S&P 500 or the Nasdaq.
So, if the S&P 500 has a current P/E ratio of 16 times trailing earnings and the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years, the PEG ratio of the S&P 500 would be (16/12), or 1.33.
The Risk of Estimating Future Earnings
Any data point or metric that uses underlying assumptions can be open to interpretation. This makes the PEG ratio more of a fluid variable and one that is best used in ranges as opposed to absolutes. The reason why five-year growth rate estimates are the norm rather than one-year forward estimates is to help smooth out the volatility that is commonly found in corporate earnings due to the business cycle and other macroeconomic factors. Also, if a company has little analyst coverage, good forward estimates may be hard to find. The enterprising investor may want to experiment with calculating PEG ratios across a range of earnings scenarios based on the available data and his or her own conclusions.
Best Uses for the PEG
The PEG ratio is best suited to stocks with little or no dividend yield. Because the PEG ratio doesn't incorporate income received by the investor in its presentation of valuation, the metric may give unfairly inaccurate results for a stock that pays a high dividend.
Consider a utility company that has little potential for economic growth. Analyst estimates may be five percent growth at best, but there is solid cash flow coming from years of consistent revenue. The company is now mainly in the business of returning cash to shareholders. The dividend yield is five percent. If the company has a P/E ratio of 12, the low growth forecasts would put the PEG ratio of the stock at 12/5, or 2.50. An investor taking just a cursory glance could easily conclude that this is an overvalued stock. The high yield and low P/E make for an attractive stock to a conservative investor focused on generating income. Be sure to incorporate dividend yields into your overall analysis. One trick is to modify the PEG ratio by adding the dividend yield to the estimated growth rate during calculations. To give us a meaningful interpretation of the company's valuation, take a look a look at the following example.
Example- Factoring Dividend Yield into the Estimated Growth Rate
This energy utility has an estimated growth rate of about five percent, a five percent dividend yield and a P/E ratio of 12. In order to take the dividend yield into account, you could calculate the PEG like this:
PE / (Growth Estimates + Yield) = (12 / (5 +5)) = 1.2
Final Thoughts on Using the PEG
Investors must always keep in mind that the market can, in the short-term, be anything but rational and efficient. While in the long run stocks may be constantly heading toward their natural PEGs of one, short-term fears or greed in the markets may put fundamental concerns on the backburner.
When used consistently and uniformly, the PEG ratio is an essential tool that adds dimension to the P/E ratio, allows comparisons across diverse industries and is always on the lookout for value.
