What is a PEG number?
What is PEG ratio, or expected earnings growth? In the article on Price to Earnings Ratio or P/E, I mentioned that this number gave you an idea of what value was placed on a company’s earnings. P/E is the most common way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and dividing it by the earnings per share (EPS). This helps identify whether a stock’s price is high or low in relation to its earnings. Some will say that a company with a high P/E is too expensive and they may be right. A high P/E can warn you that traders have raised a stock’s price past the point where acceptable short-term growth is possible. But a high P/E can also signal that the company still has strong growth prospects in the future, which can predict an even higher PPS (price per share). Because the market cares more about the future than the present, it is always looking for some way to predict it. Another indicator you can use to help you look at future earnings growth is called the PEG ratio. Price/Earnings To Growth, is a valuation metric to determine the relative trade-off between the price of a stock, the earnings per share (EPS) and the company’s expected future growth. PEG ratio is a widely used indicator of a stock’s possible fair value. You calculate the PEG by taking the P/E and dividing it by the expected growth in revenue. PEG = P/E / (expected growth in earnings). For example, a stock with a P/E of 60 and an expected earnings growth next year of 30% would have a PEG of 2 (60 / 30 = 2). What does “2” mean? Like any ratio, it simply shows you a relationship. In this case, the lower the figure, the less you pay for each unit of future income growth. So even a stock with a high P/E, but high expected earnings growth can be a good value. In other words, a lower ratio is “better” (cheaper) and a higher ratio is “worse” (expensive). A PEG ratio of one represents a fair trade-off between the cost values and the growth values, then the stock is reasonably valued given the expected growth. Similar to PE ratios, a lower PEG means the stock is more undervalued. It is favored by many over the price/earnings ratio because it also accounts for growth. If a company is growing at 30% per year, the P/E of the stock can be as high as around 30. PEG ratios between 1 and 2 are therefore considered to be within normal values. A rough analysis suggests that companies with PEG ratios between 0 and 1 can generate higher returns. Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like value may not work that way. For example, a stock with a P/E of 8 and flat earnings growth equates to a PEG of 8. This could prove to be an expensive investment. Some important things to remember about the PEG (a) Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in a company’s earnings.
The PEG ratio can suggest whether a company’s high P/E ratio reflects an excessively high share price or is a reflection of promising growth prospects for the company. (b) The PEG ratio is less suitable for measuring companies without high growth. For example, large, well-established companies may offer reliable dividend income, but little opportunity for growth. (c) A company’s growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to a number of factors: market conditions, expansion setbacks and investor hype. (d) The convention that (PEG=1) is appropriate is somewhat arbitrary and is considered a rule of thumb.
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