The PEG ratio is the Price earnings to growth ratio. It is calculated by dividing the P/E ratio by the company’s earnings growth rate for a predetermined period. And the purpose is to find that elusive superstock that grows into the stratosphere that a simple PE ratio would miss.
Background
The PEG ratio was developed by Mario Farina in the late sixties. Farina wrote about it in his book, “A beginner’s guide to successful Investing in the stock market”, from 1969. Later the great investor Peter Lynch, whose Magellan fund made an impressive 29 % annualized compounded return, between 1977 and 1990, wrote about the PEG ratio in his book “One Up on Wall Street“.
Peter Lynch’s track record is very impressive considering how much money he was managing at the end. Around 14 billion. And one of the indicators he used, to achieve this track record, was the PEG ratio. According to Peter Lynch, the price earnings ratio of any company, that is fairly priced, will equal its earnings growth rate. Lynch thought that a fairly valued company will have a PEG equal to one. And that the best companies have PEG ratios of below one. But that depends on several factors which I will touch on further below in this post.
The calculation
To calculate the PEG ratio you first need to calculate the price earnings ratio. The calculation for the PE ratio is to divide the share price by its earnings per share, or EPS. Then you get the P/E ratio. And when you have the P/E ratio you can then divide the P/E ratio by its earnings growth rate for the past five years. Although this could be any number of years used to measure that past growth. But the most commonly used for the calculation is the past seven, one or three years. Below is the calculation for the PEG ratio.
Calculation
PEG Ratio = Price earnings ratio / EPS growth
Price earnings ratio = Share price / earnings per share
EPS = Earnings per share
PEG or P/E ratio?
The price earnings ratio tells you what people are willing to pay for the stock related to its current earnings. But it does not factor in the growth rate of those earnings into the future. Or what price you are paying for that growth. Therefore the PEG ratio represent a truer picture of growth, according to its proponents. Because in the stock market the future earnings are more important than the earnings of today.
Lower is better
In short the PEG-ratio is an enhancement of the P/E ratio because it factors in future earnings through looking at expected growth. And as with the P/E ratio a low number is better than a high number. As an example a PEG ratio of one or lower is generally considered good.
Let’s take an example
If you look at several stocks within an industry some of them will have lower price to earnings ratios than others. But the companies with the higher PE ratios might have lower PEG ratios than the companies with the low PE ratios. And that is a result of their high growth rates. Therefore it is better to invest in the companies with the low PEG ratios. Because they have likely experienced higher growth in the past. And as a result they are likely to experience higher growth in the future as well. “An object in motion tends to stay in motion”, according to the First law of motion, invented by Isaac Newton.
Advantages
The PEG ratio can be a good complement to the price earnings ratio. For example some companies have both a low PE and a low PEG, which makes them doubly interesting. Further, it can tell you whether a perceived high P/E ratio is too expensive or if it is actually quite cheap. Because if that growth is high enough the high PE ratio could be warranted. And since most superstocks are also supergrowers, they often do have high PEs. But their PEG ratios might give an indication of whether that PE is warranted or not.
The idea of the PEG ratio is to find the stocks that the price earnings ratio would miss. Here is a picture of Facebook’s long term chart. The lowest PEG ratios did not always correspond with the best buy points. But the lowest PEG was also the low for the stock in the beginning of 2019. – Chart from Zacks
Weaknesses
Projected growth rates tends to be less reliable the longer into the future they are projected. As a result the PEG ratio is best for valuing companies for the current and next couple of years. Further, the growth estimates for a company can differ a lot. Because it depends on what growth rates are used for the calculation. It could be the past three, five years or some other number that are used for the calculation. Therefore it is usually a good idea to be conservative with these estimates.
Use it with caution
The PEG ratio is not magic. And it does not take into account other fundamental factors. Therefore it is wise to look at many other indicators as well. For example debt, amount of cash on the balance sheet, return on assets, return on equity and book value. And how the wider economy is doing. But also technical analysis, if that is within your circle of competence.
The PEG is not appropriate for measuring large well established dividend companies. In that case the company might offer good dividends but the future growth might be limited. And a low PEG don’t have to mean anything if the overall economy is growing very fast. Because in that environment other stocks will often have low PEGs as well. As a result it should be used for comparing stocks to other stocks. Preferably within the same industry.
Conclusion
The PEG ratio should not be used all on its own. Other tools should be used as complements, depending on what your trading style is. For example fundamentals and technicals. Because the PEG ratio does not always give an accurate view of the future. Historic growth rates might be inaccurate estimates for the future. And the PEG ratio is only a rough estimate. But it does give an indication of future growth. And for that, it is an invaluable tool.