What is Price/Earning-to-Growth (PEG) Ratio? 

The Price/Earnings-to-Growth ratio, or Price Earning Growth ratio, or simply PEG ratio, is a popular metric used by investors to evaluate the value of a stock relative to its growth potential. Unlike the traditional Price-to-Earnings (P/E) ratio, the PEG ratio incorporates a company's expected growth rate, offering a more comprehensive view of its valuation. But what exactly is the PEG ratio, and how does it help investors make better decisions? Let’s explore its meaning, formula, interpretation, and limitations. 

What is the PEG Ratio? 

The PEG ratio is an advanced valuation metric that builds on the P/E ratio by factoring in a company’s earnings growth as well. It provides insight into whether a stock is overvalued, fairly valued, or undervalued based on its growth potential. 

How to Calculate the PEG Ratio 

The PEG ratio is calculated using the following formula: 

PEG Ratio = (P/E Ratio) / Annual EPS Growth Rate 

Here’s a breakdown of the components: 

• P/E Ratio (Price-to-Earnings Ratio): The stock price divided by its earnings per share (EPS). It reflects how much investors are willing to pay for every rupee of earnings. 

• EPS Growth Rate: The projected percentage increase in the company’s earnings per share over a specific time frame, typically one year. 

• EPS: Although it is usually provided in a company’s income statement, if not available, it can be calculated using the formula (Net Income – Dividends on Preferred Stock) ÷ Weighted Average Shares Outstanding 

Step-by-Step Calculation: 

1. Determine the P/E Ratio: 
   Use the formula: P/E = Current Stock Price ÷ Earnings Per Share (EPS) 
   Example: If a stock is priced at ₹ 200 and its EPS is ₹ 10, the P/E ratio is: 
   P/E = ₹ 200 ÷ ₹ 10 = 20 

2. Identify the Annual EPS Growth Rate: 
   This is often provided by analysts as a percentage. Convert it to a whole number for calculation. For instance, a 15% growth rate is written as 15. 

3. Apply the PEG Formula: 
   Divide the P/E ratio by the EPS growth rate to calculate the PEG ratio. 

Detailed Example: 

Suppose you are analysing a stock with the following details: 

• Current stock price: ₹ 300 

• EPS (Earnings Per Share): ₹ 15 

• Projected annual EPS growth rate: 20% 

Step 1: Calculate the P/E Ratio 
P/E Ratio = ₹ 300 ÷ ₹ 15 = 20 

Step 2: Note the EPS Growth Rate 
EPS Growth Rate = 20%, which is written as 20 for the formula. 

Step 3: Calculate the PEG Ratio 
PEG Ratio = P/E Ratio ÷ EPS Growth Rate 
PEG Ratio = 20 ÷ 20 = 1.0 

This means the stock is fairly valued, as its PEG ratio equals 1. 

However, if the EPS growth rate is only 10%, the calculation would be: 
PEG Ratio = 20 ÷ 10 = 2.0 

This indicates the stock might be overvalued relative to its growth potential. 

By understanding these steps, you can better evaluate whether a stock is priced appropriately based on its growth rate. 

How to Interpret the PEG Ratio 

Here's how you can understand and interpret the PEG ratio in simple terms: 

1. PEG Ratio of 1: Fairly Valued 

A PEG ratio of 1 typically indicates that a stock is fairly valued. This means that the price of the stock is in line with its expected earnings growth rate. Investors are paying a price that reflects both the company’s current earnings and its future growth potential. 

For example, if a company has a P/E ratio of 20 and an expected annual EPS growth rate of 20%, the PEG ratio would be 1 (20 ÷ 20 = 1). This suggests that the stock is reasonably priced given its growth prospects. 

2. PEG Ratio Below 1: Undervalued 

A PEG ratio below 1 suggests that the stock may be undervalued. This could mean that the stock is trading for less than its growth potential warrants, which might indicate a good investment opportunity. Investors are paying less for the growth rate than they would for a stock with a PEG ratio of 1 or higher. 

For instance, if the P/E ratio is 15, but the projected EPS growth rate is 25%, the PEG ratio would be 0.6 (15 ÷ 25 = 0.6). This implies the stock is priced lower than its growth potential, which could make it an attractive buy. 

3. PEG Ratio Above 1: Overvalued 

A PEG ratio greater than 1 typically suggests that the stock may be overvalued. Investors are paying a higher price for the stock relative to its expected growth. This could indicate that the stock is overpriced or that high expectations for future growth are already baked into the price. 

For example, if a stock has a P/E ratio of 30, but the EPS growth rate is only 10%, the PEG ratio would be 3 (30 ÷ 10 = 3). This suggests the stock may be too expensive for its expected growth and could be overvalued. 

4. Negative PEG Ratio 

In some cases, the PEG ratio can be negative if the company’s projected growth rate is negative (i.e., expected to decline). This typically happens when a company is facing financial struggles or operating in a shrinking market. A negative PEG ratio is often a red flag for investors. 

What is a Good PEG Ratio? 

A "good" PEG value generally depends on the industry and the broader market conditions. In most cases: 

• A PEG ratio below 1 is considered attractive, suggesting undervaluation relative to growth. 

• A PEG ratio close to 1 indicates fair valuation. 

For high-growth industries, investors might tolerate higher PEG ratios, while in low-growth sectors, a PEG below 1 is preferred. 

While useful, the PEG ratio has its limitations, such as: 

• It relies on future growth estimates, which may not always be accurate. 

• The metric considers only short-term earnings growth and ignores long-term factors. 

• It may not be suitable for comparing companies in vastly different sectors with differing growth patterns 

Therefore, it is important to not rely solely on the PEG ratio while doing your analysis. Combine it with other financial metrics to get a wholesome view of the company’s performance and its growth prospects.  

PEG Ratio vs P/E Ratio 

Both the PEG ratio and P/E ratio are important metrics for evaluating a company's stock price, but they serve different purposes. The P/E ratio is a basic measure of valuation, while the PEG ratio provides a deeper understanding by factoring in growth potential. Below is a comparison of the two ratios:  

Conclusion 

The PEG ratio is a valuable tool for assessing the valuation of a stock in relation to its growth prospects. It is particularly valuable for growth investors who want to assess whether a company’s stock price reflects its potential for future earnings growth. While it offers more depth than the P/E ratio, it is essential to consider its limitations and use it alongside other metrics for a well-rounded investment analysis.