What Is PEG Ratio?
The price/earnings-to-growth (PEG) ratio is a valuation metric that takes into consideration a company’s growth rate as well, beyond the plain-vanilla price-to-earnings (P/E) ratio.
P/E ratios aren’t always useful in isolation as they don’t take a company’s growth rate into account.
For example, a growing tech company may have a very high P/E ratio and could be dismissed as being overvalued.
However, by calculating the PEG ratio on the same stock, it may indicate that the stock may still be a good buy.
The PEG ratio was popularised by the famed investor, Peter Lynch.
Calculating the PEG Ratio
To calculate the PEG ratio, we take a company’s P/E ratio and divide it by its earnings per share (EPS) growth rate.
PEG Ratio = P/E Ratio / EPS Growth Rate
Just like EPS, the EPS growth rate can come in two forms.
If the EPS growth rate takes into account the last 12 months data, this PEG ratio is known as the “trailing PEG”.
On the other hand, if the growth rate is a projected one for the foreseeable future, then we have the “forward PEG”.
For example, if a company has a P/E ratio of 20 and a projected earnings growth of 10% for the next year, its PEG ratio is 2x (20/10).
How to Make Sense of a Company’s PEG Ratio?
In general, the lower the PEG ratio, the better it is.
If a company’s P/E ratio and its expected growth rate are equal, its PEG ratio is 1x and it means that the company’s stock is fairly valued.
When a company’s PEG ratio is above 1x, it’s considered overvalued and if its PEG ratio is below 1x, it’s seen as undervalued.
A stock’s PEG ratio can also be compared with companies in the same industry to see which is worth buying.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.