What is PEG Ratio? How to Use PEG Ratio?
So far in your investment journey, have you heard of the PEG ratio? Do you know how to use the PEG ratio when analysing potential investment decisions?
There are multiple indicators and metrics available for investors to value a stock’s potential worth. The price/earnings to growth ratio (or PEG ratio, for short), is one of them.
As its name suggests, the PEG ratio takes into account the stock price and the company’s earnings per share, plus its growth rate.
In this article, we will go through the basics of the PEG ratio, and how you can use it in your own investing and trading activity at Admirals.
Table of Contents
What is PEG Ratio: An Introduction
Most of the traditional and older metrics, such as the price-earnings ratio (P/E ratio), do not take into account an important indicator: the company’s expected growth. The PEG ratio makes up for this shortcoming by adding the growth ratio into the equation. That said, all metrics come with pros and cons which should always be considered.
A company’s PEG ratio is calculated by dividing its P/E ratio by the company’s expected growth ratio (EGR), as shown in the formula below:
PEG = P/EEGR
A company’s P/E ratio should be relatively accessible to obtain and calculate since the numbers can be easily found online. However, the company’s EGR is a different story: how exactly are you supposed to put a company’s potential growth into numbers?
The fact is that there isn’t a set formula to determine a company’s growth rate - it’s all based on estimates.
Brokers, financial websites and stock market indexes can have different growth rates for the same company, all based on their own criteria and formulas. Choosing which EGR to use in order to calculate a company’s PEG is up to the investor.
Naturally, the PEG ratio can be used to determine whether to invest in a specific stock.
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What is a Good PEG Ratio for a Stock?
As mentioned earlier, the PEG ratio can be used as an investment metric.
In order to calculate a company’s PEG ratio, you first need to collect all the necessary data.
You will need to find the company’s stock price and its earnings per share. Then, you will have to decide on which growth rate to use.
Choosing one from a reliable source, such as your online broker or direct bank, is a potentially reliable option.
Once you have all the numbers ready, it’s time to calculate the company’s PEG ratio. There is a rule of thumb for PEG ratio-oriented investments:
- If the PEG ratio is 1, then the stock is considered fairly valued.
- Stocks with a PEG ratio between 0 and 1 are considered undervalued.
- When the PEG ratio is higher than 1, then the stock is considered overvalued.
Undervalued stocks should be more desirable than overvalued stocks, but that isn’t always going to be the case.
Keep in mind that bigger companies will usually have less potential for growth and lower growth rates compared to newer, less established companies. Context is important: a high PEG ratio doesn’t necessarily equal a bad investment.
PEG Ratio and P/E Ratio: How Do They Compare?
Both the PEG ratio and the P/E ratio use the stock price and the earnings per share for reference.
Likewise, both ratios can be used to determine a stock’s value. However, there are some fundamental differences between these two ratios.
The P/E ratio is a popular option among value investors for several reasons.
First of all, it’s reasonably easy to calculate, since it only requires the stock price and the EPS - which are both fairly simple to find (online).
The P/E ratio also lets investors compare different companies and can help determine which stock offers the better value. Stocks with lower P/E ratios offer potentially higher value compared to the ones with higher P/E ratios, generally speaking.
However, the P/E ratio does not take the companies’ growth into account.
The PEG ratio, as mentioned earlier, will divide a company’s P/E ratio by its growth rate and is a generally popular option among growth investors.
You can end up with significantly different values depending on which ratio you use.
While a stock can be considered a good investment from a P/E standpoint, that may not necessarily be the case from a PEG ratio standpoint. The opposite is also true.
Neither rate can be considered better or worse - again, it all comes down to your investment strategy.
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PEG Ratio: Advantages and Disadvantages
Just like any other investment strategy, the PEG ratio also has its positive and negative points. We will now look at the advantages and disadvantages of the PEG ratio metric, below.
Advantages of PEG Ratio
- The PEG ratio can complement a stock’s P/E ratio, providing additional information and offering a comprehensive outlook on whether the price is backed up by a solid growth rate.
- The PEG ratio also offers a slightly improved future outlook. EGR, which is used to calculate the PEG ratio, will usually take the stock’s prospective growth into account.
- Just like most formulas, the PEG ratio allows investors to quickly assess a stock’s value. It considerably speeds up the process, while also providing a relatively simple and quick way to compare different stocks.
Disadvantages of PEG Ratio
- As mentioned earlier, there is no way to determine a company’s growth rate, and you will find multiple EGR numbers available from different sources. In other words, obtaining the right EGR rate from a reliable source is absolutely vital, and finding the right one can be time-consuming at first.
- The PEG ratio can create a false and overly optimistic outlook at times. High growth rates aren’t always sustainable. An undervalued stock from a PEG standpoint doesn’t necessarily equate to a good investment.
- The PEG ratio lacks some important information. It doesn’t take into account key factors, such as the company’s debts, its cash flow, assets, or management quality, to name a few.
How to Analyse Stocks Using PEG Ratio
Using the PEG ratio to analyse stocks gives insight in regards to if a stock is overvalued, undervalued, or fairly priced.
First of all, you will need to obtain all the necessary figures: the company’s stock price and its earnings per share (or its P/E ratio). Next, you will need to obtain an estimated growth rate from a reliable source, such as an online or local broker.
With the three numbers in hand, you will need to calculate the company’s PEG ratio using the formula. Let’s use companies A, B and C as an example:
- Company A’s stocks sell for $35, with $2.50 earnings per share, and a 10% growth rate.
- Company B’s stocks sell for $25, with $2.00 earnings per share, and a 12.5% growth rate.
- Company C’s stocks sell for $15, with $1.00 earnings per share, and a 20% growth rate.
Using the PEG formula, A has a P/E ratio of 14 and a 1.4 PEG ratio. B has a P/E ratio of 12.5, with a PEG ratio of 1.00, while C has a P/E ratio of 1.5 and a PEG ratio of 0.5.
According to the PEG ratio, C would be the best option available, being an undervalued stock. B is a fairly valued stock, while A would be considered overvalued.
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What is PEG Ratio: Conclusion
The PEG ratio is an interesting indicator that investors can use to quickly identify growth stock options. It expands on the price-earnings (P/E) ratio, taking the company’s growth into account as well.
While the PEG ratio can be a valuable tool to help investors, it also comes with some potential drawbacks, such as finding reliable growth rate indicators.
PEG ratio calculations do not take some other important factors, such as management quality or the company’s balance sheet, into account.
As usual, it all comes down to your investment strategy. It’s absolutely crucial to understand how PEG ratios work, and the potential benefits and risks of using it as an indicator.
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What PEG Ratio is Good?
A PEG ratio which is good, generally speaking, would PEG ratio lower than 1.0.
Why is a low PEG ratio good?
A low PEG ratio is considered 'good', generally speaking, because this suggests the stock is undervalued and hence could be a good investment option.
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