What is the PEG Ratio?

Published by Thomas Herold in Accounting, Corporate Finance, Investments

'PEG Ratio' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

The PEG Ratio refers to the stock PE price to earnings ratio divided up by the earnings growth rate over a certain fixed time frame. This ratio itself is popularly utilized to ascertain the real value of a stock taking into account the firm’s earnings growth. Many analysts consider it to be a better big picture view of the company and its progress than simply using the standard PE ratio.

The misleading fact is that a lower PE ratio tends to make any stock seem like a screaming buy. When one considers the growth rate of the company along with this in the form of the PEG Ratio, it may reveal that a stock is even more undervalued considering the performance of its corporate earnings. It is also true that the amount of a PEG ratio valuation and how it indicates an underpriced or overpriced stock ranges by the type of the firm and the industry in which it is. A good set of guidelines is that any PEG ratio under the number one is beneficial.

Besides this, analysts know that any PEG ratio’s accuracy will ultimately depend on the quality of the information which is initially inputted. For example, if one deploys historical growth rates, this could deliver an unreliable PEG ratio, especially if the growth rates in the future are anticipated to be lower than the company growth rates have proven to be historically. This is why accountants and company analysts will often differentiate between the various primary methods of calculating the PEG Ratio according to whether they are relying on historical growth or anticipated future growth. To this effect, they will use the terms Trailing PEG or forward PEG to distinguish between the main two methods.

Figuring up the actual PEG Ratio is not difficult. Analysts and investors are able to do this by first computing the PE ratio of the firm under consideration. This PE ratio can be calculated out by taking the stock price of the firm and dividing it by the EPS earnings per share. After the PE has been compiled, it is easy to configure the PEG formula. One simply takes the PE Ratio and divides it out by the rate of earnings growth, whether he is using the trailing PEG or forward looking PEG.

This is a difficult enough concept that it makes good sense to consider a real world example to better understand the ideas involved. If Vodafone has a share price of $46 per share while its earnings per share for the year are $2.09, then last year’s earnings per share might have been $1.74. At the same time, Telefonica Espana has a share price of $80 with earnings per share for this year of $2.67 and an EPS from last year of $1.78. Utilizing this data, the information on each of the two companies can be calculated. The Vodafone PE ratio is 22 while the Telefonica PE ratio is 30. Yet despite this fact, the growth rate of Vodafone is 20 percent to Telefonica’s 50 percent. It means that Vodafone’s resulting PEG would then be 1.1 while Telefonica would have a significantly superior .6 PEG.

Now the fact is that numerous investors would look at Vodafone superficially and say that it seems to be more appealing because it has the lower PE of the two cell phone operating firms in question. After further investigation though, Telefonica has the higher growth rate for its PE than does Vodafone.

This means that Telefonica stock prices trades at an effective discount to its company growth rate. In the end, those investors buying Telefonica corporate stock are coming out of pocket less money per unit of earnings growth in the company. All else being equal, it makes the Telefonica stock a better valued buy than the Vodafone one in this particular example.

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The term 'PEG Ratio' is included in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.