Introduction

The PEG ratio (Price/ earnings to growth ratio) is a valuation metric for a stock that takes the growth rate of the company into consideration for calculating the proper position of the stock.  It gives a better picture than the standard P/E ratio.

In general, the P/E ratio is higher for a company with a higher growth rate. Thus, using just the P/E ratio would make high-growth companies appear overvalued relative to others. A company having a high P/E ratio with a high growth rate will seem overvalued from a P/E ratio point of view but the PEG ratio can help you see the better picture.

To know all about the PEG ratio, read on.

How PEG ratio is calculated

The PEG ratio is calculated by dividing the PE ratio of a stock by the growth rate of its earnings.

PEG Ratio= (Price/EPS​) / EPS growth rate

Where EPS = The earnings per share​

All these parameters can be found on various financial websites and NSE and BSE websites where companies upload their reports periodically.

For calculating the EPS growth rate you can consider the average growth rate of the last 4 quarters.

For example, a company with a PE ratio of 50 and an EPS growth rate of 10% will have a PEG ratio of 5.0, and a company having a PE ratio of 50 and an EPS growth rate of 25% will have a PEG ratio of 2.0.

What does it tell you?

Let us take two stocks, stock A and stock B. Stock A has a P/E ratio of 10, while stock B has a ratio of 15. From this data, stock A appears to be the wise choice for potential investors.

But this data tells an incomplete story. Let’s look into their growth figures. Let’s say stock A has an earnings growth of 8% and stock B has an earnings growth rate of 18%.

Now,

PEG ratio of stock A = 10/8 = 1.25

PEG ratio of stock B = 15/18 = 0.83

From this data, it is clear that the market is giving stock B a higher valuation because it has the capability to grow at a faster rate as compared to stock A.

In simpler terms, stock A appears to be overvalued, whereas stock B seems to be undervalued. However, the degree of undervaluation and overvaluation, as calculated from the PEG value, varies across different industries and company types. Hence, any conclusions drawn must always be contextual, considering factors such as industry trends and specific company characteristics.

How to use it

Peter Lynch, wrote in his 1989 book One Up on Wall Street that “The P/E ratio of any company that’s fairly priced will equal its growth rate”, i.e., a fairly valued company will have its PEG equal to 1.

A PEG ratio below 1 implies that the market might have inaccurately undervalued the stock, while a PEG ratio above 1 suggests that the market has potentially overestimated the stock’s worth relative to its earning prospects.

For example, let’s assume that a stock has a P/E ratio of 12 and an EPS growth rate of 10%. Therefore, its PEG ratio would be 12/10 = 1.2. It says that the market is currently overestimating such a company’s projected earning potential by 20% and thus, it is overvalued.

let’s consider another example, the hypothetical stock mentioned above. If its P/E ratio remains unchanged and its EPS growth rate is revised at 15%, then its PEG ratio would come to be 0.8. It means that the market is underestimating its earning capacity by 20%, and thus, it is undervalued. 

PEG Ratio vs P/E Ratio

The primary points of distinction between the PEG ratio and P/E ratio are discussed in the table below.

Parameters	Price Earnings to growth ratio	Price-to-earnings ratio
Definition	It is the ratio between a stock’s P/E ratio and projected EPS growth rate of that company.	It is the ratio between a stock’s market price and earnings per share.
Nature	It is part objective or historical and part forward-looking.	It can be both historical, forward-looking, or a hybrid.
Types	There is only one type of PEG ratio.	There are two types of P/E ratios – trailing and forward.
Interpretation	A PEG of 1 is equilibrium; below it, a stock is undervalued; above 1 a stock is overvalued.	The higher the P/E ratio, the more the market is willing to pay for Re. 1 of its earnings.

Regardless of the distinctions, using both the PEG ratio and the P/E ratio can provide valuable inputs for fundamental analyses of stocks, thus, supporting sound financial decisions.

Conclusion

The PEG ratio (Price/Earnings to Growth ratio) is a valuation metric that considers a company’s growth rate when assessing its stock position. Unlike the traditional P/E ratio, the PEG ratio avoids overvaluing high-growth companies. By dividing the P/E ratio by the earnings growth rate, investors can determine whether a stock is undervalued (PEG < 1) or overvalued (PEG > 1). However, contextual factors, such as industry trends and company characteristics, should be considered when interpreting the PEG ratio.

In conclusion, the PEG ratio offers investors a more comprehensive view of a company’s valuation by incorporating its growth prospects. A PEG ratio below 1 suggests potential undervaluation, while a PEG ratio above 1 indicates potential overvaluation. It complements traditional valuation metrics and can assist investors in making better-informed decisions. Nonetheless, prudent judgment should be exercised, and additional factors should be considered when using the PEG ratio for investment analysis.

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