Price Earnings Growth (PEG) Ratio

The Price Earnings Growth (PEG) Ratio is one of the first variations that were made to the Price to Earnings Ratio to make it more meaningful. The full form of the PEG Ratio is Price Earnings Growth ratio. Instead of being a two way comparison between price and earnings, the PEG ratio makes a three way comparison. The first step is to arrive at the price to earnings ratio whereas the next step is to divide this ratio by the growth rate of the company to arrive at the PEG ratio.
The PEG ratio was developed because investors argued that current stock market price is an expectation of future gains to be made by the company in question. Therefore valuing it solely on the basis of the current year’s earnings is incorrect. They realized that two companies could currently have the same earnings but the one that has been growing its earnings faster needs a better valuation. It is for this reason that they started factoring in growth rates before concluding whether the company is fairly prices.

Formula

PEG Ratio = Price to Earnings Ratio / Growth Rate
The growth rate is calculated based on historic data. Analysts could use as much data as they feel is comfortable without losing the current trend of earnings of the company in question. This growth rate is usually expected as a percentage out of 100. For example, if a company has a growth rate of 20% and a P/E Ratio of 30. Then the PEG Ratio will be:
PEG Ratio = 30/20 = 1.5

Assumptions

• Growth Rate Expected to Continue: The PEG Ratio is an extension on the P/E Ratio and therefore makes some of the audacious assumptions that the P/E Ratio makes as well. The PEG Ratio assumes that the current rate of growth of the company is expected to continue. However, in reality trends usually last for 4 to 5 years. So by the time the analyst does figure out the trend, it would be affected by the cyclical nature of business and may have changed.

Interpretation

Fairly Priced Will Equal Growth Rate: Veteran investors place a lot of faith in the PEG ratio. They believe that in the long term, the P/E ratio of the company will always equal its growth rate. Therefore if the PEG ratio is equal to 1, then the company is fairly priced. This means that investors must actively scout for companies with PEG ratios less than 1.