What is PEG Ratio?
The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the Growth rate of its earnings for a given period. While PE ratio indicates which stock is attractive based on Earnings Per Share (EPS), PEG Ratio captures a very important aspect i.e. Earnings Growth. This is the reason that companies delivering very high earnings growth rate can command a very high PE multiple.
How to read PEG Ratio?
Lower The Ratio, More Attractive is The Company.
Take for example, Company A has PEG Ratio of 1.3x while Company B has PEG Ratio of 0.9x, then as per PEG Ratio, Company B offers a better opportunity.
PEG Ratio Calculation:
To calculate the PEG ratio, one needs to first calculate the P/E ratio of the company in question. The P/E ratio is calculated as the Current Market Price (CMP) of the company divided by the earnings per share (EPS):
P/E ratio = Current Market Price / Earnings Per Share i.e. CMP / EPS
Once the P/E is calculated, the PEG ratio's formula is:
PEG ratio = P/E ratio / Earnings Growth Rate
Let us illustrate this with the help of an example:
CMP = Rs. 55; EPS this year = Rs. 3; EPS Last Year EPS = Rs. 2.7
PE Ratio = 55/3 = 18.3x
Earnings Growth = 3/2.7 = 11.1%
PEG Ratio = 18.3 / 11.1 = 1.6x
CMP = Rs. 90, EPS this year = Rs. 4, EPS Last year = Rs. 3
PE Ratio = 90/4 = 22.5x
Earnings Growth = 4/3 = 33.3%
PEG Ratio = 22.5 / 33.3 = 0.68x
In above example, one can clearly see that Company X looks attractive on PE basis, with PE of 18.3x as compared to Company Y with PE of 22.5x. However, Company Y has delivered robust earnings growth of 33% and hence it has a high enough growth rate to justify its P/E of 22.5x, as compared to growth rate of 11.1% for Company X.
In purchasing Company Y, an investor would pay less for per unit of earnings growth, as suggest by PEG Ratio of 0.68x. Thus, PEG Ratio captures this key difference, which is not optically visible while comparing valuations of companies on the basis of PE ratio.