UNDERSTANDING 'PEG RATIO'

UNDERSTANDING 'PEG RATIO'

PEG RATIO

Popularized by the legendary Peter Lynch, It’s a  ratio that will help you look at future earnings growth  You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

• PEG = (P/E) / (projected growth in earnings)

For example, a stock with a P/E of 20 and projected earning growth next year of 10% would have a PEG of 20 / 10 = 2.

WHAT DOES IT SHOW?

Consider this situation; you have a stock with a low P/E. Since the stock is has a low P/E, you start do wonder why the stock has a low P/E. Is it that the stock market does not like the stock? Or is it that the stock market has overlooked a stock that is actually fundamentally very strong and of good value?

To find the answer, PEG ratio would help. Now, if the PEG ratio is big (or close to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value.

On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason.

WHAT IS THE RIGHT PEG?

There are no hard and fast rules regarding the right PEG ratio. Normally, A PEG Ratio of 2 or below is considered excellent. A PEG Ratio of 2 to 3 is considered OK. A PEG Ratio above 3 usually means that the company’s stock is over priced.

Technically speaking

If PEG ratio=1, it means that  the share at today’s prices is fairly valued.

If PEG ratio>1, it indicates that the share is possibly over-valued.

PEG ratio<1, it indicates that  the share is possibly under-valued.

PROBLEMS WITH PEG.

The first problem is the P/E itself. Which P/E should be used for this? Is it the trailing P/E or the forward P/E? What ever P/E you may use, the ‘E’ factor in P/E   is a number not fully trusted by analysts due to the estimates that go with it.

Second, difficult part is the estimation of growth rate figures. Flaws in estimating both these figures would affect the results obtained by the PEG analysis.

What Peter Lynch has said in his one up on wall street is that “the P/E ratio of any company that’s fairly priced will equal its growth rate”. Therefore, according to him, a properly priced company will have a PEG of 1. But what if the growth rate is 0? So, the ratio doesn’t work well for all stocks . It works for a stock with normal rate of growth and earnings.

CONCLUSION.

The two most important numbers that investment analysts look at when evaluating a stock are the P/E ratio and the PEG ratio. The PEG is a valuable tool for investors to use. It reveals whether the high price of a stock is justified based on whether earnings will grow enough to continue to drive the stock higher.