PEG Vs PE Ratio

The PEG ratio is
calculated easily and represents the ratio of the P/E to the expected future
earnings growth rate of the company. This article will
discuss the positive attributes of the metric, how to best use it in your research
and what to watch out for when using it. 

Determining a Stock’s Value

Common stocks represent a claim to
future earnings.
The rate at which a company will grow its earnings going forward is one of the
largest factors in determining a stock’sintrinsic
value. That future growth rate represents everyday market prices in
stock markets around the world. 

The P/E ratio shows
us how much shares are worth compared to past earnings. Most will use 12-month trailing earnings to
calculate the bottom part of the P/E ratio. Inferences may be made by looking
at the P/E ratio; for instance, high P/E ratios represent growth stocks,
while low ones highlight value oriented stocks.
(For more insight, readUnderstanding The P/E Ratio.)

Example – Calculating the PEG

Let’s look at two hypothetical stocks to see how the PEG ratio is
calculated:

ABC Industries has a P/E of 20 times earnings. The consensus of all the
analysts covering the stock is that ABC has an anticipated earnings growth of
12% over the next five years.

XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude
that the company has an anticipated earnings growth of 40% over the next five
years.

30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75

Stock theory
suggests that the stock market should assign a PEG ratio of one to every stock.
This would represent theoretical equilibrium between the market value of a
stock and anticipated earnings growth. For example, a stock with an earnings
multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of
one. (To learn more, see Introduction To Fundamental Analysis.) 

PEG ratio results
greater than one suggest one of the following:

PEG ratio results of
less than one suggest one of the following: 

-Current P/E: 35 times earnings

-Five-year projected growth rate: 25%

-PEG: 35/25, or 1.40

-Current P/E: 16 times earnings

-Five-year projected growth rate: 15%

-PEG: 16/15, or 1.07

So, if the S&P 500 has a current P/E ratio
of 16 times trailing earnings and the average analyst estimate for future
earnings growth in the S&P 500 is 12% over the next five years, the PEG
ratio of the S&P 500 would be (16/12), or 1.33.

The Risk of Estimating
Future Earnings

Any data point or
metric that uses underlying assumptions can be open to interpretation. This
makes the PEG ratio more of a fluid variable and one that is best used in
ranges as opposed to absolutes. The reason why five-year growth rate estimates
are the norm rather than one-year forward estimates is to help smooth out the
volatility that is commonly found in corporate earnings due to the business
cycle and other macroeconomic factors. Also, if a company has little analyst
coverage, good forward estimates may be hard to find. The enterprising investor
may want to experiment with calculating PEG ratios across a range of earnings
scenarios based on the available data and his or her own conclusions. (For
more, see Great
Expectations: Forecasting Sales Growth.)

Best Uses for the PEG

The PEG ratio is best suited to
stocks with little or no dividend yield.
Because the PEG ratio doesn’t incorporate income received by the investor in
its presentation of valuation, the metric may give unfairly inaccurate results
for a stock that pays a high dividend. 

Consider the scenario of an energy utility that
has little potential for earnings growth. Analyst estimates may be five percent
growth at best, but there is solid cash flow coming
from years of consistent revenue. The company is now mainly in the business of
returning cash to shareholders. The dividend yield is five percent. If the
company has a P/E ratio of 12, the low growth forecasts would put the PEG ratio
of the stock at 12/5, or 2.50. An investor taking just a cursory glance could
easily conclude that this is an overvalued stock. The high yield and low P/E
make for an attractive stock to a conservative investor focused on generating
income. Be sure to incorporate dividend yields into your overall analysis. One
trick is to modify the PEG ratio by adding the dividend yield to the estimated
growth rate during calculations. To give us a meaningful interpretation of the
company’s valuation, take a look a look at the following example.

This energy utility has an estimated
growth rate of about five percent, a five percent dividend yield and a P/E
ratio of 12. In order to take the dividend yield into account, you could
calculate the PEG like this:

P/E / (Growth Estimates + Yield) = (12 / (5 + 5)) = 1.2

Final Thoughts on Using the PEG

Investors must always keep in mind that the
market can, in the short-term, be anything but rational and efficient. While in
the long run stocks may be constantly heading toward their natural PEGs of one,
short-term fears or greed in the markets may put fundamental concerns on the
backburner.

When used consistently and uniformly, the PEG
ratio is an essential tool that adds dimension to the P/E ratio, allows
comparisons across diverse industries and is always on the lookout for value.

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