Price To Earnings To Growth Ratio (PEG)

What is the PEG Ratio?

The PEG ratio, or price/earnings to growth, is a valuation tool which takes the p/e ratio one step further by integrating a companies expected growth numbers; hence the G in PEG.  Similar to the P/E Ratio, PEG is designed to give a relative valuation to how cheap or expensive a stock is.

The P/E ratio was lacking when used to compare one companies P/E ratio to another due to the fact that this ratio is typically higher in those companies that exhibit high growth rates; making these companies appear overvalued.  Additionally, the P/E ratio is backward looking and does not account for intangibles which can affect the future growth of the company such as growth expecatations, brand recognition, and market positioning (companies such as McDonalds have locked down the market for burgers and fries, making it very difficult for others to enter into this market)

The formula used to calculate PEG is pretty simple:  (P/E Ratio / Annual EPS Growth Rate).  A PEG of 1 suggests that a companies p/e valuation is in line with their growth estimates.  A lower value means that a stock is undervalued based on its growth expectations, while a higher suggests it may be overvalued.

Which Growth Rate is Used in PEG?

There are two possible growth rates that can be used in calculating PEG; a historical growth rate or a forward looking one.

First, some will choose to use the trailing growth rates, basically looking backwards as the P/E ratio does to give a snapshot of the company as of a prior point in time. A company may use the trailing 12 month growth rate or it may even derive it by averaging out the growth rate for a few years prior.

The forward looking growth rate is just that.  A company may forecast and annualized growth rate of earnings over the next 3 to 5 years and use this projection to calculate PEG.

Neither solution is incorrect; some like to base their opinions off of facts and some believe that the facts can change, therefore, using a forward looking number to estimate these changes.

Some Disadvantages of PEG

We discussed forward looking growth rates above.  Well, PEG mixes and matches a historical P/E Ratio with a forward looking growth rate.  Secondly, dividends are not included in this formula, thereby overlooking the companies ability to increase shareholder value.  Thirdly, growth estimates are only as good as what the company tells you.  We all know the story about the Wall Street analyst, their expecatations, and what happens when we listen to them.  Enough said.  Finally, there is no measurement included for a companies risk profile making very risky companies attractive against household names.  The fact of the matter is that many of these risky companies fluctuate in price in the area of 20% per month.  While that is possible in some of the household names, it is not probable.

In conclusion, the PEG ratio has is merits and its flaws.  Like any other valuation tool, PEG needs to be taken in context and not to be used as an end all, be all.  A thorough review of all the financial statements must be performed, especially on balance sheet where we can see the free cash flows and take a deeper dive.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...