The PEG Ratio

The PEG Ratio

Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. In its more general form, the ratio of PE ratio to growth is used as a measure of relative value, with a lower value believed to indicate that a firm is under valued.

For many analysts, especially those tracking firms in high-growth sectors, these approaches offer the promise of a way of controlling for differences in growth across firms, while preserving the inherent simplicity of a multiple.


Definition of the PEG Ratio

The PEG ratio is defined to be the price earnings ratio divided by the expected growth rate in earnings per share:

PEG ratio =  PE ratio /Expected Growth Rate

For instance, a firm with a PE ratio of 20 and a growth rate of 10% is estimated to have a PEG ratio of 2.

Consistency requires the growth rate used in this estimate be the growth rate in earnings per share, rather than operating income, because this is an equity multiple.

Given the many definitions of the PE ratio, which one should you use to estimate the PEG ratio? The answer depends upon the base on which the expected growth rate is computed. If the expected growth rate in earnings per share is based upon earnings in the most recent year (current earnings), the PE ratio that should be used is the current PE ratio. If it based upon trailing earnings, the PE ratio used should be the trailing PE ratio.

The forward PE ratio should never be used in this computation, since it may result in a double counting of growth. To see why, assume that you have a firm with a current price of $30 and current earnings per share of $1.50. The firm is expected to double its earnings per share over the next year (forward earnings per share will be $3.00) and then have earnings growth of 5% a year for the following four years. An analyst estimating growth in earnings per share for this firm, with the current earnings per share as a base, will estimate a growth rate of 19.44%.

A consistent estimate of the PEG ratio would require using a current PE and the expected growth rate over the next 5 years.

Building upon the theme of uniformity, the PEG ratio should be estimated using the same growth estimates for all firms in the sample. You should not, for instance, use 5-year growth rates for some firms and 1-year growth rates for others. One way of ensuring uniformity is to use the same source for earnings growth estimates for all the firms in the group.

For instance, both I/B/E/S and Zacks provide consensus estimates from analysts of earnings per share growth over the next 5 years for most U.S. firms.

As the risk increases, the PEG ratio of a firm decreases.  When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.

Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.
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