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.