The PEG ratio, also known as the “Price-Earnings / Growth” ratio, is a fundamental measure of whether a company’s stock is cheap or expensive. A lower ratio suggests a stock is undervalued, while a high ratio means the opposite.
The PEG ratio is a more robust measure than the PE Ratio (Price-Earnings) because it also considers how fast a company is growing. In other words, while a fast-growing company might have a higher PE ratio than a slower growing one, that doesn’t necessarily signal overvaluation.
Why Use the PEG Ratio?
The method improves on the PE ratio by factoring in growth. For example, a young company with a PE ratio of 40 that doubles its earnings annually (100% growth) will see its PE ratio shrink over time:
- Year 0: 40x PE
- Year 1: 20x PE (40 divided by 2x earnings)
- Year 2: 10x PE (40 divided by 4x earnings)
- Year 3: 5x PE (40 divided by 8x earnings)
That’s why fast-growing companies often have high PE ratios, making them look expensive and causing investors to miss out. The PEG ratio, however, can help investors account for future earnings growth. In the example above, investors will take the high 40x PE ratio and divide by 100, generating an attractive figure of 0.4.
What’s a Good PEG Ratio?
Investors should look for lower ratios. That’s when low PE ratios meet higher growth. So, what’s an acceptable number? Generally, any number below 1.0 signals “buy” while above 6.0 says “sell.”
Some Examples:
Company A:
- Stock Price = $50
- Earnings Per Share = $5
- Earnings Growth = 4%
- Price-Earnings/Growth Ratio = (50/5)/4 = 2.50
Company B:
- Stock Price = $50
- Earnings Per Share = $8
- Earnings Growth = 7%
- Price-Earnings/Growth Ratio = (50/8)/7 = 0.90
Company B outperforms Company A: it earns more per share and has faster growth. So, all else equal, investors should prefer Company B.
What are Other Benefits to the PEG Ratio?
Because the formula uses earnings (rather than book value or dividends), the PEG ratio can compare firms across many different industries. For investors looking to diversify their portfolios, that’s a significant benefit: it’s one of the few metrics that can reasonably compare fast-growing tech companies to slower-growing industrial ones.
The technique also isn’t a random construct. The formula has roots in a theoretically proven valuation method: The Justified PE ratio. The Justified PE ratio uses a more complex procedure that involves a company’s payout ratio, growth and calculated cost of equity. The PEG ratio, meanwhile, simplifies the formula into a far more usable format.
What Are Some Issues with the Metric?
Investors should use the ratio in conjunction with other metrics too. That’s because there are four types of companies where the formula can produce misleading results.
1. Young companies without earnings. Negative or zero earnings will create a negative or infinitely large PEG ratio. That means investors can’t use the PEG ratio for valuing startups or pre-profit companies
2. Companies with shrinking or zero growth. Shrinking companies will also create a negative or infinitely large ratio. That means investors should only use the method when earnings keep pace with inflation.
3. Companies with value outside of current earnings. Real estate and other asset-rich companies could have underlying value outside of earnings per share. Warren Buffett termed these as “cigar-butt” investments that can liquidate itself for more than its market value. Cash-rich companies also get undervalued by the PEG ratio.
4. Financial companies and other highly leveraged firms. The PEG ratio doesn’t account for balance-sheet risk at banks, insurance companies, and other leveraged firms. A fast-growing company with an excellent score could still warrant a lower valuation if its investment risks are high. That’s why banks and reinsurance firms typically trade for lower PE ratios.
How to Use the PEG Ratio
Investors can use stock screeners or InvestorPlace’s Portfolio Grader to narrow down to a basket of potentially mispriced companies.
The PEG ratio can then help identify companies with the best potential. Firstly, the formula immediately disqualifies firms with negative or shrinking earnings. Secondly, it favors companies with high growth and reasonable valuations. Taken together, investors who use the PEG ratio can boost their portfolios with high-potential investments.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
