The PEG ratio is one of the most popular metrics. It is so easy to calculate it. It never takes more than 10 secs even if you are not good at math.
But, what do you think, is this extremely simple metric, this PEG ratio really useful?
Let’s see. Let’s examine it a bit more on some examples.
First of all, the PEG ratio or the price/earnings to growth ratio is a stock valuation measure. Investors use it to evaluate a company’s performance and investment risk. It is a measure, so it can be calculated.
When the PEG ratio value is 1 we can say there is an excellent bond between the company’s market value and its expected earnings growth. If the PEG ratio is higher than 1, the stock is overvalued. But when the PEG ratio is lower than 1, the stock is undervalued.
The formula for PEG ratio is:
PE Ratio (Price/Earnings) / Expected Growth Rate = PEG Ratio
Assume we are examining two stocks with different characteristics
Stock A company:
price – $20/share
earnings – $4/share
expected EPS growth – 5%
Stock B company:
price – $40/share
earnings – $4/share
expected EPS growth = 20%
For stock A company
P/E ratio = $20/$4 = 5
PEG ratio = 5/5 = 1
For stock B company
P/E ratio = $40/$4 = 10
PEG ratio = 10/20 = 0.5
If we study the P/E ratio for valuation plans, we will discover that the stock B company has an advantage because it has a P/E ratio that is 50% less than that stock A company has. But if you find that company A is going to improve its earnings 5 times faster than company B, you may modify your opinion. If you use the price to earnings growth, you will see that the stock A company trades at a lower PEG ratio than stock B company. So, what can we conclude? Company A stock may give a better value.
But is that really true?
Well, there are some weaknesses connected to the PEG ratio. Earnings growth is not an isolated thing in the market minds. To get a whole picture of the stock value you have to take care of many factors such as cash flow, dividends, revenue growth, etc.
Further, when it comes to “growth” in the phrase “price/earnings to growth ratio” you will be faced with one problem when you are trying to value a company. You actually don’t know the rate of earnings growth. In the best case, you can guess or rely on Wall Street analysts. Having thin in mind, your PEG will be as good as your data is.
Well, something is good with the PEG ratio. It is very useful for smaller companies but for large companies (for example Disney or Ford) where the growth isn’t so important to total returns, it can cheat.
So, is the PEG ratio really useful?
You have to keep in mind that it isn’t a mathematical result. The method is as good as its inputs. The future growth rate could be the main problem in this PEG formula. When you or any analyst make forecasts about the future it can be wrong.
To make it clear, it is easy to calculate the PEG ratio for companies with weak growth. But, mature companies with excellent earnings and great dividends, have a slow growth rate. So, such companies will never have a PEG ratio of 1 or less. Right?
It is almost the same for companies with fast growth.
For instance, a company growing in a surplus of 30% per year will be incapable to maintain such a growth rate. Can you see how the PEG ratio is as good as its inputs? A huge amount of failures in the future earnings growth rises from a too optimistic or too pessimistic viewpoint for the company or industry. Getting an exact PEG ratio depends on what factors you use in the calculation. You may find that the PEG ratio is incorrect if you use historical growth rates. This one especially can lead to mistakes when future growth varies from the past.
Traders-Paradise wants to give some spotlight on the pros and cons of using the PEG ratio. As the answer to a question Is PEG ratio really useful, we can say: the PEG ratio is useful but only when you use it to improve a more precise discounted cash flow analysis or relative valuation.