What is the PEG Ratio?
The Price/Earnings-to-Growth (PEG) Ratio is a valuation metric that standardizes the P/E ratio against a company’s expected growth rate.
Unlike the traditional price-to-earnings ratio (P/E), which tends to be used more frequently among investors, the PEG ratio accounts for the future growth of the company.
- What does the PEG ratio measure?
- How does the PEG ratio differ from the P/E ratio?
- When is the PEG ratio most appropriate to use?
- What are some of the drawbacks to using the PEG ratio?
In This Article
PEG Ratio vs P/E Ratio
The PEG ratio addresses one of the primary weaknesses of the price-to-earnings (P/E) ratio, which is the lack of consideration for future growth.
Because the P/E ratio is adjusted for the expected earnings growth rate, the PEG ratio can be viewed as a more accurate indicator of a company’s true value.
In effect, investors can use the PEG ratio to make more well-informed decisions on whether the market valuation of a stock is currently undervalued or overvalued.
But similar to the P/E ratio, there are two notable pitfalls to the PEG ratio:
- Positive Net Earnings: The company must have positive net income (the “bottom line”)
- Later-Stage of Lifecycle: While growth is considered in the PEG ratio, companies with significant volatility in growth may not be suited for usage of the metric
For the reasons mentioned above, the PEG ratio is most appropriate for mature, low to mid-level growth companies, and near meaningless for those with negative earnings or negative projected growth.
Additionally, the PEG ratio uses an accounting measure of profit, net income. Often, accounting profits can be misleading at times due to the:
- Inclusion of Non-Cash Expense (e.g. Depreciation & Amortization)
- Differences in Accounting Treatment (e.g. Straight-Line Depreciation, Revenue / Cost Recognition Policies)
Overall, accounting measures of profits are prone to discretionary management decisions, which creates room for the “manipulation” of profits to paint a misleading depiction of the company’s profitability.
PEG Ratio Formula
The formula for the PEG ratio consists of calculating the P/E ratio and then dividing it by the long-term expected EPS growth rate for the next couple of years.
It is essential to use a long-term growth rate that is considered sustainable.
While historical growth rates could be used (or at least referenced), intuitively it would not make much sense as investors value companies based on future growth, NOT historical growth – albeit the two are closely related.
Note companies often issue potentially dilutive securities to shareholders and employees. Thus the total diluted shares outstanding must be used to avoid inflating the earnings per share (EPS) figure.
PEG Ratio Commentary Slide (Source: WSP Trading Comps Course)
High vs Low PEG Ratio
As a general rule of thumb, if a company’s PEG ratio exceeds 1.0x, the stock is considered to be overvalued, whereas a company with a PEG of less than 1.0x is considered to be undervalued.
Besides being an internal measure, the PEG ratio can be compared to a company’s industry peer group, Unlike a standard P/E ratio, the PEG ratio allows for comparisons across a broader range of company types, and notably between companies with differing growth rates.
However, this does not mean that a company with an EPS growing at 2% can necessarily be compared to a company with EPS growth forecasted at growing 50% year-over-year.
Instead, the differences in growth rates should be relatively reasonable – or said differently, companies should be at similar stages in their lifecycles to warrant a meaningful comparison.
To summarize, when it comes to comparisons of the PEG ratio among companies:
|High PEG Ratio||Low PEG Ratio|
PEG Ratio Simple Example
For instance, if a company’s latest closing share price is $5.00 and its diluted EPS in the last twelve months (LTM) is $2.00, we can compute the P/E ratio as follows:
- P/E Ratio = $30 Share Price / $5.00 Diluted EPS
- P/E Ratio = 6.0x
Assuming the company’s expected EPS growth rate is 2.0%, the PEG ratio can be calculated as:
- PEG Ratio = 6.0x P/E Ratio / 4.0% EPS Growth Rate
- PEG Ratio = 1.5x
Based on our calculated PEG ratio of 1.5x, the company would be deemed overvalued since it exceeds 1.0x.
Excel Template Download
Now that we’ve covered the PEG concept and formula, we can move to an example calculation of the PEG ratio with different scenarios. To download the Excel file, fill out the linked form below.
PEG Ratio Example Calculation Steps
Let’s get started – below are the assumptions we’ll be using for all three cases for Companies A, B, and C:
- Latest Closing Share Price: $100.00
- Earnings Per Share (EPS): $10.00
With that said, the P/E ratio can be calculated by just dividing the share price by the EPS.
- P/E Ratio = $100.00 / $10.00
- P/E Ratio = 10.0x
As of the present day, the market is willing to pay $10 for one dollar of these companies’ earnings.
The remaining step is to divide the P/E ratio by the EPS growth rate (g), which is where the differences amongst each of the companies lie.
Long-Term EPS Growth Rate:
- Company A: g = 10.0%
- Company B: g = 15.0%
- Company C: g = 5.0%
From those assumptions, Company A is our base case, Company B is our upside case (i.e. high growth), and Company C is our downside case (i.e. low growth).
The calculation of the PEG ratio in Excel has been shown below.
Once the process is done for each scenario (Company A, B, and C), we get the following PEG ratios:
- Company A: 1.0x PEG Ratio
- Company B: 0.7x PEG Ratio
- Company C: 2.0x PEG Ratio
While there are further complexities that must be taken into consideration, from our exercise, we’d interpret these findings are:
- Company A is fairly valued (i.e. neither undervalued nor overvalued)
- Company B is undervalued and potentially a profitable investment
- Company C is overvalued and a potential “sell” if a portfolio holding
If we were to rely solely on the P/E ratio, each company would have a P/E ratio of 10.0x.
But upon adjusting for the differences in the expected EPS growth rates, we derive more insights regarding the market values of the three companies.
In conclusion, a screenshot of the finished output sheet can be found below.