PEG ratio explained: How is it used to assess a stock?

The price-to-earnings (PE) ratio is one of the most widely used metrics among retail investors, who want to quickly determine if a stock is undervalued or overvalued. It is straightforward to calculate but does not answer whether a company’s PE is appropriate for the forecasted growth rate. To address this limitation, investors turn to another ratio called the PEG ratio.  

PEG ratio measures the relationship between the PE ratio and earnings growth to provide with a more complex story than simply what the PE alone gives us. It can tell us whether a stock is undervalued or overvalued by analysing both the current price of the stock and the expected growth rate of the company. The PEG ratio is calculated as follows:   

PEG = PE ratio/EPS growth  

Although earnings growth rates can vary across industries, a PEG of less than one is considered to be undervalued since its price is lower than the expected growth rate while a PEG of greater than one might be considered as overvalued since the stock price may be too high as compared to the company’s expected growth in earnings.  

How is it used?  

A major advantage of using a PEG ratio is the ability to use the ratio to compare it over different industries. This cannot be done while using PE alone because different industries may have different prevailing PE ranges and cannot be compared fairly. By adding expected growth into the mix, one can do away with this limitation and can analyse companies across different industries.   

For example, let us consider two companies i.e. a technological company and a textile company. Let’s say that the tech stock trades at 25 times earnings while the textile stock trades at a much more modest PE of 10x. From a strict value standpoint, one can make the argument that the textile stock is a better value because it trades at a much lower P/E. However, now, let's factor in the earnings growth rate.  

Let's assume that the tech company, being in a fast-growing industry, has a five-year projected growth rate estimated at 50 per cent while the textile company being in a sunset industry has a relatively lower growth rate of 10 per cent. Now, using the PEG ratio, we can calculate:   

Tech stock PEG = (25 PE/50 per cent growth rate) = PEG of 0.5x
Textile stock PEG = (10 PE/10 per cent growth rate) = PEG of 1x  

A trader focussed on value might deem it reasonable to buy the textile stock solely based on PE even though the tech stock has a PEG ratio that is half the value of the textile stocks’ PEG.   

Bottom-line  

Since the popular PE ratio does not factor in future earnings growth alone, a PEG ratio is more helpful and can provide better insight into the stock price. It gives us a forward-looking perspective unlike the PE ratio and is a valuable tool for investors to determine a stock’s growth prospects.   

Since the growth estimate may vary over time, an investor should best use the PEG ratio to compare companies that have exhibited an earnings growth rate within a consistently reasonable range. Buying an expensive stock with a high growth rate may be fine as long as the company remains in the growth phase. However, eventually, the high growth rate is bound to slow. And when that day comes, the stock may be marked down by investors and traders as they adjust to the reduced expectations for the company.