This is an ultimate guide on how to calculate Price Earnings to Growth Ratio (PEG) ratio with thorough interpretation, analysis, and example. You will learn how to use its formula to identify if a stock is undervalued.
Definition - What is PEG Ratio of a Stock?
The price earnings to growth ratio, also known as the PEG ratio, takes the price earnings ratio one step further.
This valuation ratio compares a company’s current share price with its current earnings per share, and then measures that P/E ratio against the rate at which the firm’s earnings are growing.
The price to earnings to growth ratio gives you a more refined look at a potential investment’s value, since an attractively high P/E ratio doesn’t always hold up under scrutiny once you take the company’s growth rate into account.
This ratio can also show you how expensive or inexpensive a company’s stock is in relation to the rate at which its earnings are currently growing, and the rate at which they’re expected to increase over the long-term.
This offers a big advantage over calculating a firm’s P/E ratio alone, since that figure only considers the company’s value in terms of the earnings it’s currently generating.
A lower ratio often indicates that a business is currently undervalued in the marketplace, based on its earnings performance.
The formula for calculating this ratio looks like this:
Price Earnings to Growth Ratio = PE Ratio / EPS Growth Rate
Similar to the P/E ratio, with this ratio you have the option of working with either a forward-looking growth rate or a trailing growth rate for this calculation.
Depending on which version of the price earnings to growth ratio formula you use, you’ll end up with different information, all of which can be useful in your investment analysis of a particular business.
A forward annual growth rate generally predicts and examines a period of time up to five years in the future, while a trailing growth rate is based on a company’s established annual earnings growth over the past year, or the average rate from multiple years.
You should bear in mind that when you use a firm’s historical information in the price to earnings to growth ratio, you’ll end up with a factual outcome.
A ratio that incorporates a predicted growth rate for future earnings, while valuable, is still only based on an expectation of a firm’s future financial performance.
Read also: How to Find a Company's Intrinsic Value
PEG Ratio Calculator
Okay now let's consider a quick example to see exactly how to calculate this ratio in real life.
Perhaps you’re considering buying stock in Company KK for your investment portfolio, and you’ve already calculated the firm’s P/E ratio as 10.
Now you’d like to investigate that result further, by taking Company KK’s past and predicted earnings growth rates into account.
By studying Company KK’s financial statements, as well as the analyst predictions for its anticipated earnings growth, you can determine both its trailing and its forward price earnings to growth ratios, as follows:
- Annual EPS Growth Last Year 12%
- Annual Predicted EPS Average for Next Five Years 15%
How do you find the price earnings to growth of this company?
This example shows you that Company KK is currently selling for less than its earnings growth rate. This implies that it’s undervalued in the marketplace.
If the analysts are correct, and Company KK’s earnings continue to grow as predicted, it could represent a good investment for your portfolio.
Interpretation & Analysis
Now that you know the formula and how to calculate this ratio, let's find out how this ratio helps you determine if a stock is undervalued or overvalued.
The lower a firm’s price earnings growth ratio result, the less expensive its stock is.
How to Use This Ratio to Value Stocks
- Overvalued signal: PEG Ratio > 1.0
- Undervalued signal: PEG Ratio < 1.0
So what is a good PEG ratio?
Generally speaking, a PEG ratio of less than 1 is usually considered both an attractive outcome, and a good buy.
But analyzing the result of a company’s price earnings growth ratio is not always a straightforward process.
While a lower ratio result can mean that a stock is a good deal, since it’s selling below its intrinsic value in terms of how quickly its earnings are growing, it can also mean that the stock price is low because the business is in financial trouble.
It’s important to remember that a trailing PEG ratio doesn’t provide any useful information about a firm’s long-term prospects.
Whether or not you should consider a firm’s stock to be overpriced or underpriced in terms of its market value, will also vary with the type of company it is, and with the industry it occupies.
Finally, you should always perform your investment analysis using the same method, particularly when you’re making comparisons between companies.
Cautions & Further Explanation
As you can see, it can be very easy to let yourself be swayed subjectively by the result of a firm’s price earnings growth ratio, because there are many different ways to interpret the outcome.
If you only consider a company’s historical performance, by calculating its trailing PEG ratio for example, your interpretation of the result could prove to be inaccurate if that company’s earnings are expected to increase or decrease significantly going forward.
It’s crucial that you take all of the information about a business into account when you’re considering a potential investment, including both its trailing and its forward price earnings to growth ratios.