If you’ve ever invested, you’ve probably heard of utilizing the price-to-earnings (P/E) ratio to determine whether a company is a smart buy at its present price. While the PEG ratio is a valuable tool for identifying stocks that appear to be selling below their fundamental value, it does not necessarily provide the complete picture. In looking at a good PEG ratio, we’ll discuss its formula, how to calculate it, give an example of how it’s used, examine the best uses for the PEG ratio, and list the best stocks.
What Is the Price/Earnings-to-Growth (PEG) Ratio?
The PEG ratio is a variant of the P/E ratio that indicates how much investors are ready to pay for each dollar of business earnings. A lower P/E ratio is often regarded to be preferable because it indicates that the price is supported by fundamentals rather than conjecture. Some experts believe that by taking into account a company’s future development, the PEG ratio provides a full picture of a stock’s value, particularly for fast-growing corporations.
A P/E ratio is a time-honored statistic that investors use to identify companies that are trading below their intrinsic value. The simple P/E formula divides the current stock price by the earnings per share of the company. Assume a corporation has a P/E ratio of 10. In effect, you’d be paying $10 for every $1 of earnings, making it relatively costly when compared to a stock with a P/E of 3, which would cost $3 for every $1 of earnings.
P/E ratios for fast-growing companies, such as IT startups, do not always provide the most accurate indication of their valuation. Often, the perceived value of these enterprises is based on the potential for future profits rather than current earnings. As a result, their P/E ratios are often high. However, this does not necessarily imply that they are overpriced. Some investors believe that including a company’s growth rate in the valuation equation makes the PEG ratio a more appropriate tool to assess valuations for such stocks.
How the PEG Ratio Works
When combined with a stock’s P/E ratio, the ratio can convey a significantly different picture than P/E alone. Consider a stock with a high P/E ratio, which may be considered overpriced and not a suitable investment. If that same firm happens to have high growth predictions and you calculate the PEG ratio, you might get a lower figure, indicating that the stock is still a solid investment.
On the other side, if you have a company with a low P/E ratio, you may believe it is cheap. However, if the company is experiencing a bad year and does not expect significant growth, the P/E ratio may be high, indicating that you should avoid purchasing the shares.
What Is a Good PEG Ratio?
A P/E ratio of 1.0 or lower, on average, indicates that a company is properly priced or even undervalued. A P/E ratio greater than 1.0 indicates that a stock is expensive. In other words, PEG ratio investors seek stocks with a P/E ratio equal to or less than the company’s predicted growth rate.
Investors should, of course, not rely solely on the P/E ratio or any other single financial metric. Furthermore, whether a company’s P/E ratio is less than or greater than 1.0 does not indicate if it is a good or terrible investment.
The P/E ratio can be useful in evaluating similar companies based on their respective growth rates. However, given the predictions that go into the P/E Ratio and the uncertainty surrounding any company’s future growth, the P/E Ratio should be used as only one of several criteria in analyzing any investments.
How to Calculate the PEG Ratio
Before you can calculate the PEG ratio, you must first understand its formula. Let’s take a brief look at the PEG ratio formula we’ve provided below:
PEG Ratio=EPS GrowthPrice/EPS
where:
EPS = The earnings per share
To find the PEG ratio, you must first calculate the P/E. To calculate the PEG ratio, an investor needs three things:
- Stock price
- Earnings per share
- Expected rate of growth
A stock’s price is its current market price, which does not require an estimate. The complications stem from attempts to forecast earnings per share and growth.
Earnings Per Share:
Earnings can be approached in two ways. The first method is to use a company’s earnings from the previous year, also known as TTM, for the trailing twelve months. This method has the advantage of not requiring an estimate. The company’s financial statements show past earnings. The negative is that past earnings may not accurately reflect the company’s future prospects.
As a result, some investors prefer to base their investment decisions on the consensus forecast of a company’s earnings for the coming year. While this strategy may more accurately reflect the company’s current situation, it does necessitate an estimate. As a result, adopting a forecast of future earnings can add to the results’ uncertainty.
Aside from considering TTM or future earnings, one must also evaluate whether any adjustments should be made to a company’s stated results. One method is to adjust reported earnings to account for any capital expenditures required to keep the business running. This strategy yields what Warren Buffett refers to as “owner’s earnings.” Owner’s earnings represent the fact that a company may need to utilize some of its profits to replace machinery, computer systems, or other equipment just to keep operations running at their current level.
Rate of Growth:
A future growth rate, like future earnings, necessitates estimates. Past growth rates can be used to estimate future growth rates. While this may be fair in some situations, an investor should assess if a company’s past growth rates are representative of its future potential. There may be compelling reasons to predict that future growth will halt or accelerate.
Given the variability that can exist in both future profits and growth rate assumptions, PEG ratios calculated using alternative assumptions are frequently found. As we’ll see later, these various calculations might produce wildly disparate answers.
Example PEG Ratio Calculations
Consider Apple, Inc.’s (AAPL) P/E ratio as an example. According to current research, Apple’s P/E ratio is 3.68. At the same time, Morningstar quoted Apple’s PEG ratio at 2.66, which is significantly lower. A closer look at how each website can calculate the PEG ratio explains why the results differ.
The TTM P/E ratio is calculated by Zacks. It employs both TTM and growth for earnings per share (EPS). This eliminates the requirement for either element to be estimated. As a result, any company that is predicted to grow significantly over the following year will have a larger P/E ratio.
Morningstar, on the other hand, uses the “mean EPS estimate for the current fiscal year” as the earnings figure. It bases growth on predicted earnings per share. Morningstar’s inputs result in a lower P/E ratio because Apple is predicted to increase over the following year.
Neither option is fundamentally superior, and an investor may benefit from considering both. Furthermore, an investor should explore estimating a range of growth scenarios to determine how alternative outcomes affect the company’s existing valuation.
What Does the PEG Ratio Tell You?
While a low P/E ratio may make a stock appear to be a good investment, the PEG ratio, which takes into account the company’s growth rate, may tell a different picture.
The PEG ratio indicates how pricey a company is in comparison to its growth rate. The price-to-earnings ratio (P/E) is the most commonly used ratio among investors, but it has a significant benefit over the PE ratio in that it adjusts the P/E for growth. A higher P/E ratio often indicates quicker growth rates, but the PEG allows investors to evaluate stocks with high and low P/E ratios based on growth rates.
The PEG ratio also allows investors to quickly determine how inexpensive a stock is in relation to its growth rate. When all else is equal, a lower PEG ratio is preferable.
A P/E ratio of one was traditionally regarded as appropriately valued, with less than one being undervalued and more than one being overvalued. However, over the last decade, price-to-earnings ratios have gotten stretched due to the expansion of the technology sector, which trades at a higher valuation than traditional sectors such as oil or tobacco. As a result of this transition, you’re unlikely to find many stocks with a PEG ratio of less than one these days, as many of the most expensive PEG ratio stocks on the market, particularly in sectors such as cloud computing, don’t even have profits.
Advantages and Disadvantages of the PEG Ratio
There are several advantages to employing the PEG ratio. The main advantage is that it takes into account a company’s growth rate, making it more convenient than the P/E ratio, which needs investors to do their own growth comparison. With the P/E, investors can opt to utilize a company’s P/E ratio based on earnings in a future year, i.e., a forward P/E. Unlike most other ratios, the PEG is also forward-looking, reflecting a stock’s predicted earnings rather than its past performance.
The PEG, on the other hand, can be more difficult to apply because growth rates aren’t always available or precise. If a company’s P/E ratio is low, it could be because the market does not believe the growth estimate. Furthermore, because the number of years in the P/E ratio varies, apples-to-apples comparisons might be problematic. In the case of Meta, analysts predict earnings per share to fall this year, thus it wouldn’t even have a P/E ratio if we only used a one-year estimate. In comparison, the P/E ratio for the next three years would be 0.86, substantially lower than the present 1.74.
It’s important to remember that earnings estimates get less accurate over time, so the earnings consensus for next year should be closer to actual results than the five-year forecast.
The PEG ratio, like other valuation indicators, should be used in conjunction with other tools. Investors should also evaluate the balance sheet, debt burden, and cash flow, which are not reflected in the P/E ratio or other income-based value metrics.
Is a High or Low Peg Ratio Better?
In general, a decent PEG ratio is less than 1.0. PEG ratios of more than 1.0 are generally regarded as unfavorable, implying that a company is overvalued. Meanwhile, PEG ratios less than 1.0 are thought to be better, indicating that a company is undervalued.
What Does a Negative Peg Ratio Mean?
A negative P/E might result from a negative P/E ratio or negative profit growth projections. In either situation, it indicates a corporation that is losing money or is likely to grow at a negative rate.
What Does a Peg Ratio of 1 Mean?
A PEG ratio value of one, in principle, shows a perfect correlation between the company’s market value and its predicted earnings growth.
Is Peg Ratio Better Than PE Ratio?
Because the P/E ratio does not account for future profit growth, the PEG ratio provides more information about a stock’s price. Because it provides a forward-looking view, the PEG is a significant tool for investors in estimating a stock’s future possibilities.
What Does a Peg Ratio Less Than 1 Mean?
In general, a PEG number less than one indicates that the company is undervalued in this metric. When a company does not have earnings, investors can help establish value by comparing its stock price to its sales.
What Is Amazon’s Peg Ratio
Amazon.com’s peg ratio averaged 1.02 from December 2018 to December 2022. From fiscal years ending in December 2018 to 2022, Amazon.com had a median peg ratio of 1.30.
What Is Costco Peg Ratio?
The PEG ratio for Costo is derived as the PE Ratio / TTM Earnings Growth Rate.
Conclusion
The PEG ratio may be a more accurate estimate of value than the P/E ratio alone. The PEG ratio helps investors analyze a company’s pricing in relation to its future profits growth potential by taking growth into account.
At the same time, the P/E ratio introduces additional uncertainty by requiring future growth to be projected. As a result, while the P/E ratio is a useful statistic for analyzing possible investments, it should not be used in place of a thorough examination of a company’s financial statements, management, the industry as a whole, and other pertinent aspects.
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- How to Value a Company: Examples, Formula, Process & Guide
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- HOUSING EXPENSE RATIO: What It & How To Calculate it
- Price To Earnings Ratio (P/E Ratio) Formula & Usage
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