The Price/Earnings-to-Growth, or PEG ratio, is a very handy number for spotting growth share bargains. But what exactly is this metric, what does it tell investors, and what are the limitations of relying on this metric? Let’s take a look.
What is the PEG ratio?
As the name suggests, the PEG ratio looks at the relationship between a stock’s price, the underlying company’s earnings, and the expected future growth. It allows investors to gain some insight into the value of a company whilst also factoring in its ability to expand earnings in the future – something the standard price-to-earnings, or P/E ratio, doesn’t do.
It was popularised by both Peter Lynch, author of the classic One Up on Wall Street, and by Jim Slater in his excellent Zulu Principle books. And it’s still used widely today among growth investors. So, how do you calculate it?
How to calculate the PEG ratio
The formula for the PEG is fairly straightforward, and it can be calculated as follows:
PEG Ratio = P/E Ratio ÷ Growth
Alternatively, investors can use:
PEG Ratio = (Share Price ÷ Earnings per Share) ÷ Growth
PEG Ratio = (Market Capitalisation ÷ Net Income) ÷ Growth
Where growth represents earnings growth either on an overall or per-share basis.
The growth rate can be trailing or leading. In other words, investors can use the historical growth rate of earnings (usually a five-year average) or projected earnings for the next 12 months (usually from company-issued guidance).
Using a trailing growth rate assumes that the company will continue to grow its profits in line with the historical average, whereas a leading growth rate assumes that management’s outlook is spot on.
In reality, both figures are prone to inaccuracies that can mislead investors into thinking a stock is over or undervalued.
PEG Ratio example
Let’s look at an example.
ABC Plc has just reported its full-year results. The stock trades at a share price of 100p, and the latest earnings per share has landed at 10p. Over the last five years, profits have been growing at an average rate of 5%. However, in the management’s outlook, the firm has recently signed a new contract with a customer that is expected to deliver larger profits next year. As such, ABC is expecting to see an increase in earnings by 10%.
The basic P/E ratio of ABC is 10.0, as calculated by taking the share price of 100p and dividing it by the earnings per share of 10p. We can then divide the P/E ratio by an appropriate growth figure to calculate the PEG ratio.
On a trailing basis, we divide by the 5% historical growth rate, which returns a PEG ratio of 2.
On a leading basis, we divide by the expected growth rate of 10% for the following year, giving us a PEG Ratio of 1.0.
But how do we interpret this information?
What is a good PEG ratio?
Much like the standard P/E ratio, the PEG ratio is a relative valuation metric. Therefore, by itself, it doesn’t mean much. Investors need to compare it with other companies operating within the same industry to determine whether a stock is undervalued.
However, both Peter Lynch and Jim Slater have highlighted certain thresholds that investors should be on the lookout for.
Generally speaking, the smaller the PEG, the better value an investor is getting per unit of growth. So, if we look back at the previous example of ABC Plc, notice that the PEG gets smaller when the growth rate increases.
Furthermore, when the PEG ratio sits at a value of 1.0, it indicates that a stock is fairly valued, according to Peter Lynch. And when a value is less than 1.0 that suggests a potential buying opportunity. However, Jim Slater also warns investors that when a PEG falls below 0.7, that could be a warning sign of an imminent earnings slowdown and, therefore, requires further investigation.
By this logic, ABC Plc looks reasonably priced on a leading basis but expensive on a trailing basis. However, when looking at the company’s peer group, it turns out the average PEG ratio sits at 2.5. Therefore, relatively speaking, even on a trailing basis, ABC Plc is undervalued compared to its peers.
Is a negative PEG ratio bad or good?
A negative P/E ratio is meaningless for investors and is created by a company being unprofitable. However, for the PEG ratio, a negative value can also be created by the expectation of negative growth. And that signals to investors that the company may be in trouble. Therefore, a negative PEG ratio is usually a warning sign that something might be wrong.
However, trouble in an unprofitable business can sometimes be hidden by the PEG ratio and lure investors into a trap. Suppose both the earnings of a business and the expected growth rate are negative. In that case, the PEG ratio will be positive and possibly even fall below 1.0, signalling a buying opportunity that is actually an investment trap.
PEG ratio versus P/E ratio
Both the PEG and P/E ratios are closely related. Both base the valuation of a business on earnings; however, the P/E ratio fails to take future growth into account. This can make the P/E ratio far less useful.
Generally speaking, the lower the P/E ratio, the better the value. However, by not including growth in the calculation, investors can be lured into buying cheap-looking stocks that are actually expensive due to an incoming slowdown in earnings growth.
Similarly, a stock trading at a high P/E ratio may look expensive. Yet this may also be misleading if the underlying company is expected to grow at a significant pace in the future.
Since the PEG ratio takes future earnings into consideration, it’s a far more reliable metric in determining whether a stock is over or undervalued.
What are the limitations of the PEG ratio?
Despite its numerous benefits, the PEG ratio has its limitations. We’ve already discussed the issue of negative earnings paired with negative growth, potentially misleading investors. However, there are other drawbacks to relying on this metric that investors need to be cautious of.
The PEG ratio is generally believed to only work effectively for high-growth companies delivering industry-beating performance. Therefore, this metric has little to no use in valuing large-cap enterprises paying out most of their earnings to shareholders via dividends.
There is also the issue of selecting a growth rate. As previously mentioned, both the leading and trailing approaches for estimating growth are fraught with inaccuracies. And given the PEG ratio is highly sensitive to the selected growth rate, this metric suffers from the ‘garbage in, garbage out’ problem.
It’s also challenging to calculate the PEG ratio part way through the year, with most reported figures relying on end-of-year values. This is problematic when comparing two businesses with different reporting year-ends. That’s why some analysts recommend calculating a rolling PEG, which is based on the estimates of the 12 months from the present rather than a specific financial year. However, this also opens the door to inaccuracies creeping into the calculation.
Alternative valuation ratios
In the cases where the PEG ratio is unsuitable, investors may want to rely on alternative valuation metrics and methods. Fortunately, there’s a wide range to choose from, each suitable under different circumstances, including: