One of the limits of P/E is that it doesn’t factor in the growth in underlying earnings. Back when Sam Walton first began opening Walmart stores, using the P/E on its own wouldn’t have accounted for the rapid growth that would soon come from all the money being spent on expansion. To make up for this flaw in P/E, you can use the price-to-earnings-to-growth (PEG) ratio. The extra factor, if you know it, could give you a better idea of the stock’s true value. For example, suppose that XYZ Company’s P/E ratio is 20, and its expected growth rate is 35 over the next year, meaning that its PEG ratio is .57 (20 P/E ÷ 35 growth rate). Conversely, suppose that ABC Company has a P/E of 15, making it more attractive than XYZ from purely a P/E valuation. However, ABC’s expected growth rate is 10 for the next year, making its PEG ratio 1.5 (15 P/E ÷ 10 growth rate). Although ABC has a lower price-to-earnings multiple, its lower growth rate may indicate that its stock price is overvalued compared to its expected growth over the next year. On the other hand, XYZ’s higher P/E ratio might be justified, since the company has a much higher expected growth rate.
How to Calculate the PEG Ratio
To find the PEG, you must first calculate the P/E. To do that, take the share price, and divide it by the earnings per share (EPS). EPS is a basic way to express how much income or profit is earned for each share on the market. You can find a stock’s EPS, along with its share price, on almost any stock quote website. Once you have the P/E, you simply divide that by the growth in earnings per share to arrive at the PEG ratio.
How the PEG Ratio Works
Using the PEG ratio in tandem with a stock’s P/E can tell a very different story than using P/E alone. Take the example of a stock with a high P/E, which might be viewed as overvalued and not a good investment. If that same stock happens to have good growth estimates, and you were to calculate the PEG ratio, you might come up a lower number, which would tell you that the stock may still be a good buy. On the other hand, if you have a stock with a low P/E, you might assume that it is undervalued. But if the company is having a rough year and does not expect major growth, you may get a high PEG ratio, which would mean that you should pass on buying the stock.
What’s a Good PEG Ratio?
The standard number for a safe or even great PEG ratio varies from one industry to the next, but as a rule of thumb, a PEG of below 1 is best. When a PEG ratio is 1 on the dot, the market’s perceived value of the stock is in balance with what you can expect of its future earnings growth. If a stock had a P/E ratio of 15, and the company projects its earnings to grow at 15%, for example, it would have a PEG of 1. When the PEG exceeds 1, there are two ways to read it: either the market expects more growth than fundamental estimates predict, or increased demand for a stock has caused it to be priced too high. A ratio of less than 1 indicates that stock market analysts have set their estimates too low or that the market has underestimated the stock’s growth prospects and value.
Limits of the PEG Ratio
The biggest danger in using the PEG ratio to find cheap stocks comes from being too tied to high hopes. Keep in mind that growth estimates are just that; they are not set in stone or backed by a promise. Using the most conservative figure you have access to can help you avoid paying too much for a stock that doesn’t grow as you might expect it to. By banking too much on the promise of the future, a stock might appear to be a great bargain, though in fact is quite worthless. When traders as a whole become too optimistic, the result is a stock market bubble. This happened in 2000 with the dot-com bubble, and again in 2008 with the housing bubble. As you may recall, it wasn’t too long before both “popped.” When traders realize that their hopes were too high, which had led stock prices to rise too high, those bubbles burst with sudden stock crashes.
Dividend-Adjusted PEG Ratio
A simple PEG ratio works best for stocks that don’t offer dividends. However, many stocks do, such as major corporations and blue-chip stocks. Those dividends cut into the company’s true EPS, which throws off the whole formula. But there is a way to account for this factor. If the stock you’re watching offers a dividend, you might prefer to use a dividend-adjusted PEG ratio. To come up with this figure, you must slightly adjust the standard PEG ratio. Instead of simply dividing the P/E by the expected earnings growth, you must first add the expected earnings growth to the dividend yield. You then divide the P/E by that output.
