Fundamental analysis of stocks to determine their actual value is a common practice amongst investors. While the process might sound daunting, some metrics facilitate the purpose conveniently. One of these metrics is the Price-to-earnings ratio. However, it has a lesser-known and more useful cousin that facilitates a greater understanding of a stock’s real value, and that is the PEG ratio.

A PEG ratio, or Price/earnings-to-growth ratio, draws the relationship between a stock’s P/E ratio and projected earnings growth rate over a specific period.

This metric can provide a much more informed view of a stock in relation to its earning potential.

In other words, it allows investors an idea about a stock’s actual value like a P/E ratio does while also factoring in its growth potential. Therefore, for more fundamental analysis, the PEG ratio is crucial.

As mentioned previously, it denotes the ratio between a stock’s P/E ratio and its projected growth in earnings. It shall be noted that the P/E ratio, thus considered for PEG ratio is the trailing version and not the forward P/E ratio.

Therefore, the PEG ratio formula is written as:

*Price/earnings-to-growth = (Market price of stocks per share/EPS) / Earnings per share growth rate*

A PEG ratio is both grounded in objective information and is forward-looking – a factor that lends more credibility to the metric.

*Example: Company A recorded earnings worth of Rs.12 lakh in FY 20 – 21. The market price of its share at that time was Rs.10, and it had a total of 150,000 outstanding shares. Its EPS witnessed a 2% growth over the last year and is projected to grow by 2.5% for the next year.*

Therefore, its EPS, as per the records of FY 20 – 21, is Rs. 8 (1200000 / 150000).

Ergo, P/E ratio = 10 / 8 = 1.25

Hence, PEG ratio = 1.25 / 2.5 = 0.5

Estimations concerning a company’s growth rate can stretch across different periods. It can be 1-year, 2-year, 3-year, and so forth. However, the higher the number of years, the more there is a chance of inaccuracy in results.

To find such growth rate projections, investors can refer to such a company’s own announced projections. They can also make use of estimates published by analysts at their websites.

For near-about accuracy, investors can compare such estimated growth rates to a company’s track record. This helps to check whether it is in line with their past performance. They should also factor in considerations like change in business conditions, breakthroughs by a company, etc.

The P/E ratio denotes the rupee amount a shareholder needs to pay for a particular stock for earning Re. 1 of its income. Therefore, when simply basing comparison among stocks on their P/E ratios, a low value is more lucrative compared to higher values.

For instance, assume there are two stocks – stock A and stock B. The former exhibited a P/E ratio of 20, and the latter had a ratio of 25. In that case, the former would be a more reasonable investment avenue.

However, when the aspect of a projected growth rate is factored in, it might tip the scales. Let’s consider the above example of stock A and stock B. Estimations present an EPS growth rate of 18% for stock A, while for stock B it is 30%.

In that case,

**PEG ratio stock** A = 20/18 = 1.11

PEG ratio stock B = 25/30 = 0.83

From these values, it can be concluded that while stock A had a lower P/E ratio, the market still overestimated its earning potential. In the case of stock B, even though it had a higher P/E ratio, it is still trading at a discount when considering its future income projections.

In other words, stock A is overvalued, and stock B is undervalued. However, to what extent a stock is undervalued and overvalued, as per PEG value, varies from one industry to another. Therefore, inferences should always be in the context of industry, company type, etc.

*PEG Ratio equal to, above, and below 1: What does it mean?*

According to Peter Lynch, an eminent financial and value investor, a PEG ratio of 1 denotes equilibrium. This equilibrium is between the perceived value of a stock’s worth and its earning potential. For better understanding, take a look at the following PEG ratio analysis.

*For instance, if a company has a P/E ratio of 20 and its earnings growth rate is also projected as 20, then it means that the market has correctly perceived its value. *

On that note, a PEG ratio above and below 1 would imply that the market has wrongly perceived such stock’s value. In case the PEG ratio of a stock is above 1, it means the market has overestimated its worth in relation to its earning potential.

*For example, let’s assume that stock A has a P/E ratio of 12 and an EPS growth rate of 10%. Therefore, its PEG ratio would be 12/10 = 1.2. It says that the market is currently overestimating such a company’s projected earning potential by 20% and thus, it is overvalued.*

In case the PEG ratio of any stock is below 1, it means that the market has underestimated its value in relation to its projected earning potential.

*For instance, let’s consider the hypothetical stock A mentioned above. If its P/E ratio remains unchanged and its EPS growth rate is revised at 15%, then its PEG ratio would come to be 0.8. It means that the market is underestimating its earning capacity by 20%, and thus, it is undervalued. *

However, there are other inferences to PEG ratios that are above and below 1. A PEG ratio above 1 could mean that investors consider its EPS growth rate inaccurate or the stock might have heightened demand due to other related factors.

Similarly, a PEG ratio below 1 could also mean that investors consider the projected growth rate to be inaccurate, or it might imply a lower demand for that stock due to other relevant factors.

The primary points of distinction between the PEG ratio and P/E ratio are discussed in the table below.

Parameters |
Price Earnings to growth ratio |
Price-to-earnings ratio |

Definition | It is the ratio between a stock’s P/E ratio and projected EPS growth rate of that company. | It is the ratio between a stock’s market price and earnings per share. |

Nature | It is part objective or historical and part forward-looking. | It can be both historical, forward-looking, or a hybrid. |

Types | There is only one type of PEG ratio. | There are two types of P/E ratio – trailing and forward. |

Interpretation | A PEG of 1 is equilibrium; below it, a stock is undervalued; above 1 a stock is overvalued. | The higher the P/E ratio, the more the market is willing to pay for Re. 1 of its earnings. |

Regardless of the distinctions, using both PEG ratio and P/E ratio can provide valuable inputs for fundamental analyses of stocks, thus, supporting sound financial decisions.

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