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Investors have used the price to earnings (P/E) ratio to help value stocks for years. This ratio is calculated by dividing the current price of the stock by its earnings per share. Well-known investment manager Peter Lynch helped popularize an updated method of valuing stocks in the 1990s. This newer method is called the price to earnings to growth (PEG) ratio. To calculate the ratio, the price to earnings ratio is divided by the company's estimated annual growth rate over the next few years.
The annual growth estimate of a company can be obtained from online investment sites or a stockbroker. If a person has enough knowledge about the company, he can also estimate the growth rate himself. Past earnings, the value of the company's brand and employees, its ability to deliver the product or service, and the overall industry and economic outlooks are some factors to consider when calculating a company's annual growth estimate.
The lower the PEG ratio, the more the stock could be undervalued. Investors looking for value stocks prefer low PEG ratios. A PEG ratio of 1 is considered the baseline for analysis, and means the stock is valued fairly. A stock with a PEG ratio above 1 may be considered overvalued. A PEG ratio of below 1 indicates that the stock could be undervalued and may be a good buy for the investor.
An advantage to using the PEG ratio is that it adds future earnings potential to the historic P/E ratio equation. The P/E ratio uses only the past 12 months of earnings to calculate a stock's value. As a result, the PEG ratio has more significance for valuing stocks with high growth potential.
Including future growth estimates is also one of the challenges when using the PEG ratio. The growth rate is a projection of future earnings and is not guaranteed. Since the growth rate is variable, the PEG ratio is not foolproof.
The PEG ratio may also be less relevant in evaluating the stock price of strong, established companies. These companies may not experience explosive growth, and may have PEG ratios higher than 1. These stock prices can still go up, and the companies may provide value by paying dividends to shareholders. The dividend factor would not be included in the PEG ratio equation.
PEG ratios have both advantages and disadvantages when it comes to estimating the value of a stock purchase. There is no foolproof method of determining which stocks to buy. As a result, PEG ratio is usually one of many tools investors use to make buying decisions.