In the strategy of value investing investors are trying to find out the actual price of a stock. The process of finding value stock might be intimidating but some metrics make it simple.
One of them is the price to earnings ratio. But this ratio might not be able to provide an accurate picture and more informative metric that provides more understanding of the actual price of a stock and that is the PEG ratio.
What is PEG Ratio?
The price/earnings to growth ratio establishes a relationship between the P/E ratio and the growth rate of future earnings.
The price/earnings to growth ratio also known as the PEG ratio shows the company's Price/Earnings ratio divided by its growth rate of future earnings (Basically it takes the next 2-5 years).
It is based on the thought that a company should have an earnings growth rate enough to justify a P/E ratio.
PEG ratio gives a more accurate picture than the P/E ratio and the PEG ratio doesn't take into account any future growth rates but is calculated using a historical growth rate. It is a way to calculate whether a stock is overpriced or underpriced.
How to calculate the PEG ratio?
As already mentioned above the price/earnings to growth ratio defines a relationship between the P/E ratio and the growth rate of future earnings.
The price/earnings to growth ratio are calculated by dividing the P/E ratio by the growth rate of future earnings.
The formula for price/earnings to growth ratio is given below:
Price/earnings to growth ratio= (P/E ratio / Growth rate of future earnings)
Whenever calculating the growth rate of future earnings, then an investor should compute the last five years earnings per share.
After calculating the last five years earnings per share, an investor understands how much percentage earnings the company makes per year.
Hence, it provides a good conception of forecast future earnings growth and has a good understanding of the company's business model.
What does the PEG ratio tell you?
The PEG ratio measures whether a stock price is undervalued or overvalued based on the growth pattern of the business and remember stock prices are fluctuated by demand and supply.
Generally, the peg ratio is less than 1, which may indicate the company is considered undervalued based on future earnings outlooks.
If the peg ratio is more than 1, that shows the company's stock is overvalued and that investors consider its earnings growth rate inaccurate.
At last, the peg ratio is equal to 1, which indicates the company is fair valued and indicates a perfect correlation between the company's share price and its projected earnings growth.
It should be noted the peg ratio takes into account the historical growth rate of the company and does not take into account the future growth rates. It is not a standard metric that indicates whether the investment is good or bad.
Hence, the results of the PEG ratio varies Under which sector the company is operating. As a rule of thumb, investors usually prefer a peg ratio less than 1, relative to growth potential.
According to the most popular value investor Peter Lynch, a PEG ratio of 1 denotes the company is fairly valued. If a company's PEG surpasses 1.0, it is considered overvalued and when a company's PEG lower than 1.0 is considered undervalued.
How to use the PEG ratio with an example?
Here are two companies, the first company is A and the second company is B. Determine the following information for two conjectural companies.
Company A:
The current market price of A company is Rs. 48 and EPS of Rs. 1.80 in 2019 and assumes in 2020 EPS of Rs. 2.15
Company B:
Company B's current market price 85 and EPS of Rs. 1.82 in 2019 and assumes EPS of Rs. 2.70 in 2020.
The following data can be computed for both companies.
Company A:
P/E ratio = 48 / 1.80 = Rs. 26
Estimated growth rate = [(2.15 - 1.80) / 1.80] × 100 = 19%
PEG ratio = (26 / 19)
PEG ratio = 1.36 times
Company B:
P/E ratio = 85 / 1.82 = Rs. 46
Estimated growth rate = [(2.70 - 1.82) / 1.82] × 100 = 48%
PEG ratio = 46 / 48
PEG ratio = 0.95 times
Most of the investors will notice company A and it is more desirable because it has a lower P/E ratio as compared to company B.
But when it comes to Company B, it does not have a high reasonable growth rate to justify its P/E.
However, company B is trading at a discount price to its growth rate and investors are buying it because of paying less per unit of earnings growth.
PEG Ratio vs. P/E Ratio
The price to earnings ratio is a valuation ratio that indicates what the investors are willing to pay for a stock per rupee of income.
But the price to earnings ratio has one limitation, that is, the P/E ratio formula does not consider the estimated future growth of the company. The PEG ratio provides a more accurate and trusted measurement than the P/E ratio.
The PEG ratio is calculated based on the P/E ratio numbers. Adding crucial elements projected future growth in the PEG ratio makes it more valuable to the equity investors to represent a financial interest in a company's future earnings.
What is a good PEG ratio?
The PEG ratio of price-earnings to growth ratio is a valuation metric that measures whether the stock is undervalued or overvalued and helps to take an investment decision to the investors in the current market situation.
Generally, a PEG ratio value of 1 suggests an exact correlation between the market price of a company and its estimated earnings growth.
PEG ratios of more than 1 are mainly considered unfavourable, inferring the stock is overvalued. Oppositely, PEG ratios lower than 1 are considered congruent to the investors, suggesting the stock is undervalued.
What are the limitations of the PEG ratio?
The PEG ratio has several limitations as follows.
1. The major limitation of PEG is that the future growth forecast can be incorrect. An analyst or investor may predict future growth but it may be wrong.
2. PEG ratio doesn't consider dividends. Suppose a well-established company has good earnings and pays a handsome dividend, but the growth rate is quite slow.
Hence, a company heightening earnings at 1% and may not be going to sell when a P/E ratio of 1.
3. PEG ratio would not be provided proper measurement in asset-heavy businesses such as real estate, telecom etc.
