The price/earnings-to-growth ratio, or the PEG ratio, is a metric that helps investors value a stock by taking into account a company’s market price, its earnings and its future growth prospects. Compare the PEG ratio to the price-to-earnings ratio (P/E ratio), a related measure that evaluates how expensive a stock is by comparing the company’s stock price to its earnings. The PEG ratio can provide a more complete picture of whether a stock is overvalued or undervalued.
What Is the PEG Ratio?
The PEG ratio compares a company’s P/E ratio to its expected rate of growth, a key factor for assessing its value. A company that’s expected to grow its revenue, earnings and cash flow at a high rate is, all other things being equal, more valuable than a company with little growth opportunity.
Growth companies tend to have higher P/E ratios than value companies for this reason. Investors are willing to pay more for potential growth: When they see the potential for growth, high near-term prices aren’t necessarily a problem.
The question remains, however, how much an investor should be willing to pay for growth. A “growth at any cost” approach can result in paying too much even for a great company. The PEG ratio can help an investor put a price on a company’s rate of growth.
How to Calculate the PEG Ratio
The math behind the PEG ratio is straightforward. One simply divides a company’s P/E ratio by its expected rate of growth.
A company with a P/E ratio of 20 and an expected growth rate of 10%, for example, would have a PEG ratio of 2 (20 / 10). As simple as the math is, there are complexities to the PEG ratio.
To calculate the PEG ratio, an investor needs three things:
- Stock price
- Earnings per share
- Expected rate of growth
The price of a stock is its current market price, which doesn’t require an estimate. The complexities arise from attempts to estimate earnings per share and growth.
Earnings Per Share
There are two general approaches to earnings. The first is to use a company’s earnings from the past year, commonly referred to as TTM, for trailing twelve months. The advantage of this approach is that it doesn’t require an estimate. Past earnings are reported in the company’s financial statements. The potential disadvantage is that past earnings may not reflect the company’s future prospects.
As a result, some investors prefer to use the consensus estimate of a company’s earnings over the next year. While this approach may better reflect the company’s current position, it does require an estimate. As a result, using an estimate of future earnings can add more uncertainty to the results.
Beyond using TTM or future earnings, one must also consider whether to make any adjustments to a company’s reported earnings. One approach is to adjust reported earnings for any capital expenditures required to maintain the business. This approach results in what Warren Buffett calls “owner’s earnings.” Owner’s earnings reflect the fact that a company may need to use some of its profits to replace machinery, computer systems, or other equipment just to maintain its current level of operations.
Rate of Growth
As with future earnings, a future growth rate requires estimates. One can base a growth estimate on past growth rates. While this may be appropriate in some cases, an investor should consider whether past growth rates are indicative of a company’s future prospects. There may be good reasons to believe that future growth will slow or quicken.
Given the variance that can go into both future earnings and growth rate assumptions, one often finds PEG ratios calculated using different assumptions. These different calculations, as we’ll see below, can lead to very different results.
What Is a Good PEG Ratio?
As a general rule, a PEG ratio of 1.0 or lower suggests a stock is fairly priced or even undervalued. A PEG ratio above 1.0 suggests a stock is overvalued. In other words, investors who rely on the PEG ratio look for stocks that have a P/E ratio equal to or less than the company’s expected growth rate.
Of course, investors shouldn’t rely exclusively on the PEG ratio or any other single financial metric. Furthermore, just because a company’s PEG ratio is less than or greater than 1.0 doesn’t mean it’s a good or bad investment.
The PEG ratio can be helpful in comparing similar companies in reference to their respective growth. But given the estimates that go into the PEG Ratio and the uncertainties of any company’s future growth, one should use the PEG Ratio as just one of many factors in evaluating any investments.
Example PEG Ratio Calculations
As an example, let’s look at the PEG ratio for Apple, Inc (AAPL). Based on recent analysis, Zacks reported Apple’s PEG ratio at 3.68. At the same time, Morningstar reported Apple’s PEG ratio at a much lower 2.66. A closer examination of how each website calculates the PEG ratio reveals why the results vary.
Zacks calculates what it calls a TTM PEG ratio. It uses both TTM for earnings per share (EPS) and growth. In doing so, it avoids the need to use estimates for either factor. The result is a higher PEG ratio for any company that is expected to grow significantly over the next year.
In contrast, Morningstar uses the “mean EPS estimate for the current fiscal year” for the earnings number. For growth, it uses projected earnings per share. Because Apple is expected to grow over the next year, Morningstar’s inputs result in a lower PEG ratio.
Neither approach is inherently better, and it may be appropriate for an investor to consider both methods. In addition, an investor should consider making a range of growth estimates to see how different outcomes affect the current valuation of the company.
The Bottom Line on the PEG Ratio
The PEG ratio is arguably a more meaningful measure of value than the P/E ratio alone. By factoring in growth, the PEG ratio helps an investor evaluate a company’s price in relation to its future earnings growth potential.
At the same time, the PEG ratio adds an additional level of uncertainty, as future growth must be estimated. Thus, while the PEG ratio may be a useful metric for evaluating a potential investment, it should not replace a fundamental analysis of a company’s financial statements, management, its industry as a whole and other relevant factors.
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