When we divide the price to earnings ratio by the growth rate for a certain period of time, we get the price to earnings to growth ratio (PEG ratio). While taking the company’s earnings growth into account, the PEG ratio is used to determine the stock value. It provides a clear and more effective picture than the P/ E ratio. Generally, the stock is treated well to buy if it has a low P/ E ratio associated but when we include the company’s growth rate into calculations, the estimates get changed.
Before calculating the PEG ratio, one needs to calculate the P/ E ratio of the company. PEG ratio is the P/ E ratio divided by the earnings growth rate.
P/ E ratio = Price per share/ EPS
PEG ratio = P/E ratio/ earnings growth rate
A lower EG ratio reflects a stock being undervalued at a given earning performance. The application/ interpretation of the same value of PEG ratio may be different for different companies and industries; hence the growth aspects could be different as well. The general rule of thumb says that the ratio desirable should be below one.
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The inputs used play a big role in determining of the accuracy of the PEG ratio. In case the future growth rates are assumed to deviate from the historical rates, the PEG hence calculated will be inaccurate. The words “forward PEG” or “trailing PEG” are used often to differentiate between future growth and historical growth.
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Let’s exemplify the formulae and interpret the results. Assume two hypothetical companies X and Y with the following stats:
X’s price per share = Rs 23
X’s EPS this year = Rs 1.045
X’s EPS last year = Rs 0.87
Y’s price per share = Rs 40
Y’s EPS this year = Rs 1.335
Y’s EPS last year = Rs 0.89
Given this information, the following data can be calculated for each company:
X’s P/E ratio = Rs 23/ Rs 1.045 = 22
X’s earnings growth rate = (Rs 1.045/ Rs 0.87) – 1 = 20%
X’s PEG ratio = 22/ 20 = 1.1
Y’s P/E ratio = Rs 40/ Rs 1.335 = 30
Y’s earnings growth rate = (Rs 1.335/ Rs 0.89) – 1 = 50%
Y’s PEG ratio = 30/ 50 = 0.6
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Having a lower P/ E ratio between the two, company X will be preferred by the investors but as compared to Y, it has a lower growth rate too which does not justify the PE. Company Y is trading at a lower price per unit of earning. Thus, PEG is an important ratio for everyone who invests monetarily, especially in stocks.