Price-to-Growth Ratio (PEG ratio) is a method of measuring the value of a share. The calculation of PEG ratio takes into account the market price of the company, earnings per share and future growth potential of the company. A PEG ratio is considered to be an accurate indicator of the actual value of a share and a stock with a low PEG ratio is considered to be undervalued as in the price-to-earnings ratio (PE ratio).The PEG ratio is considered to be an advanced method of determining whether the stock is undervalued or overvalued.
As the company’s PE ratio is compared to the expected earnings growth, the PEG ratio presents a complete picture of the actual value of the shares. Companies expected to increase cash flow, revenue and profits at higher rates tend to be more valuable than companies with low growth potential.
As a result, the price-to-earnings ratio of growth stocks tends to be much higher than that of value stocks. That is, investors tend to pay more for potential growth. Immediate high prices make no difference to the benefits of higher growth in the future.
However, the question of how much the investor should be willing to pay for growth is important. In any case, if growth is considered paramount, then even a good company has to pay a very high price. Thus, in such a case, the PEG ratio helps the investor to set a fair price for the growth rate of the company.
How to calculate PEG ratio and its complexity
The math behind the PEG ratio is simple. The PEG ratio is known by dividing the company’s PE ratio by the expected growth rate. For example, a company with a PE ratio of 20 has an expected growth rate of 10% and a PEG ratio of 2. Although the math is easy, there are some complications with the PEG ratio.
To calculate the PEG ratio, investors need three things, namely: the company’s share price, earnings per share, expected growth rate. Here, the share price of the company means the immediate market price of the company. Therefore, it is not a matter of complexity as the market price should not be estimated. However, earnings per share and expected growth are subject to speculation, which complicates the PEG ratio.
There are two approaches to earnings per share. First, based on the earnings per share mentioned in the quarterly or annual financial statements published by the company. The advantage of this is that since the actual earnings per share of the company is mentioned in the statement, there is no error that can be caused by the investor’s estimate. However, only the company’s past earnings are reported in the financial statements.
And, past earnings do not necessarily represent the future of the company. As a result, some investors base their second-choice estimates on how much the company will earn next year. The results can be uncertain as the company’s future earnings need to be estimated here. Since the earnings per share has to be estimated, the PEG ratio becomes a bit complicated.
Hence, the expected growth rate of the company is also subject to the same estimates as earnings per share. Here, one has to estimate the future growth rate of the company’s revenue or profit. Some estimate the future growth rate based on the company’s past growth rate. It also works in some cases. However, investors should consider whether the past growth rate is an indicator of the company’s future prospects.
Sometimes a company is likely to take growth much higher by adopting a very different and dynamic strategy than in the past. Even if they have been slow in the past, companies with aggressive plans are likely to make a leap in growth. Therefore, the strategy of the affiliated company, future plans should be looked at more carefully.
PEG ratios calculated based on different estimates can be found as the company’s future earnings per share and expected growth rate may vary. Due to which, the PEG ratio of the same company may also vary according to the calculation.
What is the best PEG ratio?
As a general rule, a PEG ratio of 1 or less is considered good. Such a PEG ratio indicates that the share price is reasonable or may be undervalued. A PEG ratio greater than 1 indicates that the stock is overvalued. In other words, investors who rely on the PEG ratio choose stocks that are equal to or greater than the company’s expected growth rate PE ratio. However, investors should not base their analysis on the PEG ratio alone.
Also, having a PEG ratio greater or less than 1 does not necessarily mean right or wrong investment. The PEG ratio helps to compare the growth rates of similar companies. However, due to the uncertainty used in calculating PEG ratios and the uncertainty of the company’s future growth rate, PEG ratios should be considered as one of the various but important methods of company analysis.