PEG Ratio

Fundamental analysis is the practice that puts together all relevant quantitative and qualitative data of a company. It is a fundamental and valuable method for investors who wish to invest for more extended periods.

It is important to look at while performing fundamental analysis. The Price/Earnings to Growth ratio extends the famous P/E ratio. This ratio helps investors understand whether or not a stock is undervalued or overvalued, depending on the final number.

In a nutshell, it is a stock's price-to-earnings (P/E) ratio further divided by the company's growth rate for a specified time. Unlike the P/E ratio, it also factors in the company's expected earnings growth, providing a comprehensive fundamental view of the company.

It also shares a few similarities with the P/E ratio. For instance, it is interpreted the same way as the P/E is, i.e., a lower value refers to an undervalued stock, and a higher value refers to a comparatively overvalued stock.

 In this case, the benchmark number is 1, anything less than one is considered undervalued, and a number above 1 refers to an overvalued stock.

The use case for this ratio is broader than the P/E ratio, as the P/E ratio only tells us the expense of a share based on historical earnings.

A firm might or might not perform in line with its historical earnings, as various internal and external factors associated with earnings can lead to inaccurate current value assumptions.

Therefore it becomes imperative to take into consideration the future performance of a company.

In this article, we will try to simplify and break it down for you, so that next time, you can make better decisions as an investor.

What is the PEG Ratio Formula?

The calculation for this ratio is very similar to that of the P/E ratio. However, in addition to dividing share price by earnings per share, the value is further divided by the growth rate in earnings per share.

It can also be understood as dividing the P/E ratio by the EPS growth rate. The exact formula for calculating the ratio is as follows:

The components of the ratio includes the following:

1. Share price

Share price, or stock price, is the amount an investor would have to spend to buy one share in a particular company. The share price is not fixed and can vary depending upon that share's forces of demand and supply.      

Higher demand would lead to an increase in the share price of a company. The demand can be high for various reasons such as - the high performance of the company, dividends being paid out by the company, or any other positive announcement made by the management.

Similarly, lower demand would result in a decrease in the share prices of the company. But, again, lower demand can have various reasons, such as - poor performance of the company, negative news about the management or operations, etc.

Investors can find the share price of a company through various sources or platforms such as - Google, Yahoo Finance, Investing.com, Tradingview, etc. These websites display current, accurate share prices of listed companies in various international markets.

The following is an example of Apple's share price on Yahoo Finance:

2. Earnings per share (EPS)

This is calculated as a company’s net profit divided by the outstanding common shares. EPS is an essential indicator of a company’s overall profitability.

The EPS of a company can vary depending on various factors such as - changes in profitability, changes in the number of outstanding shares, or payment of dividends by the company. Also, EPS is sometimes adjusted for certain extraordinary items.

Earnings per share are used to calculate ratios such as - P/E Ratio, Price/Earnings to Growth Ratio, etc. Therefore, it is imperative to understand the EPS of a company in depth.

 Investors no longer have to calculate a company’s EPS manually; instead, they can find the EPS of a company in two ways:

• Annual report of a company - Companies usually mention all essential and relevant ratios in their annual reports so that their shareholders do not have to search elsewhere for the same.

• External websites - If one does not want to scan through lengthy annual reports, plenty of websites calculate these ratios for you, such as Yahoo Finance, Marketwatch, Investing.com, etc. 

Here is an example of Amazon’s EPS found through Yahoo Finance:

Here, you will find two kinds of EPS. 

• Basic EPS - This only factors in a company's issued and outstanding common stock.

• Diluted EPS - These factors impact common share price, preferred shares, warrants, stock options, partially convertible debt, etc.

3. EPS Growth Rate

The earnings per share growth rate refers to the speed at which a company can grow its profitability (EPS). It is usually calculated as a percentage of the historical EPS data available.

Investors tend to prefer companies with higher EPS growth rates as it represents a company that can grow faster than its competitors. However, it is also essential to understand that higher EPS growth rates are mostly not sustainable over the long term.

• EPS1 - Most recent EPS data 
• EPS2 - Older EPS data (base)

For instance - if Company X's EPS is growing at 20% CAGR for five years, then in all likelihood, the percentage growth in EPS of X will moderate over the next few years because of the following reasons :

1. Entry of competitors - When more businesses enter the same industry, they take away existing competitors' market share and pricing power. Hence growth rates usually come down for such companies.

2. Input cost increase (Inflation) - Companies that use a lot of inputs have to go through periods of input cost inflation. Wherein the cost of acquiring and purchasing necessary inputs goes up, impacting the company's profitability and margins.

How to Interpret the PEG Ratio

It is often found that new investors in the market only consider the P/E ratio to evaluate whether a stock is undervalued or overvalued.

This could be the wrong approach. First, a low P/E ratio does not guarantee that a stock is undervalued, as the company's future earnings growth might be irregular or lesser than expected.

Factoring in the stock's price/earnings to growth ratio may be completely different. A lower ratio often means a stock is truly undervalued given its future earnings expectations. On the other hand, a higher ratio means that a stock is currently overvalued, given its future earning potential.

Peter Lynch, a well-known investor who popularizes the PEG ratio, believes that a company's price-to-earnings (P/E) ratio and expected growth should ideally be equal for a stock to be reasonably valued.

According to Lynch, a ratio of 1 represents a fairly valued company, while anything above 1 depicts an overvalued stock. Conversely, an undervalued share should ideally have a PEG ratio below 1.

Now, the question arises: What is a good PEG ratio?

There is no such absolute number that depicts a perfect ratio. Like most ratios, this must also be seen compared to peer companies or the industry averages.

Let us take an example to explain this point.

Apple’s PEG ratio stands at 3.48, which looks significantly overvalued if taken in isolation. However, let us look at some competitors of Apple who belong to the same industry.

The following things can be observed:

1. All three companies - Apple, Microsoft, and Dell, look significantly overvalued when examined separately.

2. However, when we compare the three companies, it can be found that in comparison to Apple, Microsoft and Dell are relatively undervalued as Apple’s price/earnings to growth ratio stands at 3.48, while the other two companies have a PEG ratio of 2.12 and 2.16.

3. The industry price/earnings to growth ratio for these companies is 2.20. Therefore by comparing with the industry benchmark, Apple still looks overvalued, while Dell and Microsoft look fairly valued.

Another vital factor in deciding whether a stock is trading at a discount or not is to see whether the price/earnings to growth ratio justifies its EPS growth rate.

Let us apply this concept to the above example.

EPS Growth Rate of Apple Inc.

EPS Growth Rate of Microsoft Corp

EPS Growth Rate of Dell Technologies 

After doing some basic calculations, we can compute the following :

Apple Inc.

P/E Ratio = 29.68

EPS Growth Rate = 71.34%

PEG Ratio = 3.48

Microsoft Corp.

P/E Ratio = 33.6

EPS Growth Rate = 39.52%

PEG Ratio = 2.16

Dell Technologies

P/E Ratio = 8.79

EPS Growth Rate = 67.12%

PEG Ratio = 2.12

A rational investor will prefer stocks like Dell Technologies, as despite an EPS growth rate of 67%, it is trading at a P/E ratio of 8.79, along with a price/earnings to growth ratio lower than that of its listed competitors.

However, it is essential to note that apart from ratio analysis, there are several other fundamental factors related to the business which must be considered before making an investment decision. 

Risks of Using the PEG Ratio

The ratio is a significantly better measure of value than the P/E ratio. We have looked at how comparing a company's price/earnings to growth ratio against its competitors can help an investor make better decisions.

This is because, unlike the price-to-earnings ratio, this factors in the future earnings growth potential.

However, like any other indicator, there are certain risks and disadvantages of using this ratio:

• It cannot substitute a complete fundamental analysis of a company, as several other quantitative and qualitative factors are at play, such as management of the company, expansion plans, other financial statements, etc.

• It usually considers the future estimates of 2-3 years. This usually will not help investors make investment decisions for long-term investments.

• Also, since the ratio considers the EPS growth rate of the company, it may sometimes induce investors to buy a faster-growing company that has performed well over the past 1-2 years. 

   However, there is no guarantee that such companies will perform well over the long term.

• Investors must also glance through the free cash flows of a company, as they are significant drivers of valuation and growth. Free cash flows also represent the cash a company can obtain from its profits.

This is why financial modeling helps individuals make better investment decisions, and it covers all bases related to the complete fundamental analysis of a company.

• Growth companies tend to have higher P/E and PEG ratios than value companies. This is because investors are willing to pay a premium over and above the market price to enjoy the future growth of a company.

Researched and authored by Aditya Das | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Book Value Per Share
• Enterprise Value
• Free Cash Flow
• Net Present Value
• Time Value of Money