How to use the PEG ratio for stock picks

Know why the PEG ratio is important for your investment analysis.

  • By Paulina Likos,
  • U.S. News & World Report
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The price-to-earnings growth ratio, or PEG ratio, can be used to identify your next stock buying opportunity.

One of the basic investment ratios used for valuing a stock, reviewing the PEG ratio can be a quick test to measure a stock's value and further growth prospects.

Earnings growth is a fundamental component of the PEG ratio. For a company to show merit, it needs to exhibit earnings growth.

The PEG ratio is often compared with the price-earnings ratio, another valuation metric, since it's a component of the PEG's formula. While there are advantages to using PEG over P/E, investors should also be aware of the PEG ratio's limitations.

A single ratio alone can't give investors the full picture of a stock's value. But the PEG ratio can be a starting guide in your stock evaluation process, so investors need to make sure they're using it with the utmost accuracy:

  • PEG ratio versus P/E ratio.
  • How to use PEG.
  • How to calculate PEG.
  • Why PEG is valuable for investors.

PEG ratio versus P/E ratio

The PEG ratio tells investors the relationship between a stock's current stock price, earnings per share and future earnings growth. The PEG is the byproduct of the P/E ratio.

Stand-alone, the P/E ratio is a valuation metric that measures a company's stock price compared to its earnings per share, but one of its shortcomings is it doesn't consider a company's expansion. PEG goes a step further to help estimate the future growth of a company. The PEG is considered a more holistic ratio compared to P/E because PEG factors in both the P/E and how fast a company can grow its earnings.

A low PEG means the stock may be undervalued. If the PEG is high, then the stock might be overvalued compared to its growth rate.

How to use the PEG Ratio

Investors can make an accurate reading of a stock's PEG when compared with other similar stocks in the same industry. It wouldn't be suitable to do a cross-sector comparison because a low PEG in one sector could represent a favorable value while a low PEG in another sector could mean something different.

Holmes Osborne, principal at Osborne Global Investors in Odessa, Missouri, says the PEG ratio only applies to profitable companies.

"Unprofitable companies can be great buys when they return to profitability. Companies with no growth that pay out their cash flows as dividends can be good buys, too. Companies that have hidden assets or are misunderstood can be great buys," Osborne explains.

To capture an overall understanding of a company's financial health, investors may want to review a company's full financial history. The PEG ratio is used for evaluating earnings growth over the short term or at a specific point in time, typically within one to three years, and may not be as helpful when looking at earnings backward in time.

How to calculate the PEG ratio

The PEG formula is the P/E ratio (the share price divided by earnings per share), divided by the expected earnings growth rate. The benchmark value of 1 is used to assess the valuation of a stock's PEG.

As a general rule of thumb, a PEG of 1 tends to be appropriately priced. If the PEG is less than 1, it's said to be undervalued because investors can gain from a stock's projected earnings by buying more shares for less. Conversely, if the PEG is more than 1, the stock is said to be overvalued and investors may be purchasing it at a higher price for a company's future earnings growth. Here are a few examples of three companies in the same industry:

Company A's PEG: P/E ratio of 30 and an expected earnings growth rate of 20% = 1.5

Company B's PEG: P/E of 20 and a growth rate of 25% = 0.8

Company C's PEG: P/E of 10 and an expected earnings growth rate of 10% = 1

The results tell us that Company B could be a better deal since it has a lower PEG than Company A and Company C because you can purchase shares at a discount to its growth rate, and it has the fastest expected growth rate. Company A has a PEG of 1.5, which would suggest that it may be overvalued. Lastly, while Company C has the lowest expected growth rate out of the three companies, it holds a fair market value.

Since earnings are the foundation of the PEG ratio, capturing accurate earnings forecasts is important to have an accurate PEG to assess a stock's value.

Some companies won't give you a projected growth rate. In this case, the PEG may not be the best ratio for that particular stock. Peter Davies, CEO at Jigsaw Trading in Bangkok, a trading software that offers tools to help traders in the global futures markets, says if the estimate of future growth cannot be certain, investors can overcome this shortcoming by looking at historical growth and the reasons for any projected increase or decrease in growth.

Why PEG is valuable for investors

PEG is a popular valuation ratio that's easy to use. This ratio allows value investors to do a comparative check on stocks within the same industry that have varying rates of growth to determine which investment fits their strategy.

At the time of this writing, the PEG ratios for automobile manufacturers General Motors (GM), Ford (F) and Tesla (TSLA) are 0.79, 0.45 and 1.19, respectively. Robert Johnson, professor of finance at the Creighton University's Heider College of Business in Omaha, Nebraska, cites these numbers as a comparison. "A value investor would look at these numbers and likely conclude that while Tesla has extremely high growth prospects, GM and Ford have more conservative valuation levels and likely a higher margin of safety," he says.

Investors will use the PEG ratio to see which stock could offer a better return on their investment but shouldn't solely rely on the PEG when making investment decisions. Investors should have other valuation metrics in their toolkit.

Investors should not assume that when comparing two companies with similar P/E ratios but one has a higher expected earnings growth rate than the other to immediately think that the lower PEG is a better investment. Johnson says investors must realize that expected growth rates are just expectations.

"There is no one source for obtaining expected growth rates," he says. When calculating PEG ratios for individual stocks, Johnson offers that investors should get expected data from the same source. You can simply find the components to calculate the PEG ratio from a company's earnings reports and financial statements or from websites like Yahoo! Finance or Zacks.

To make a thorough assessment of a company, investors may consider looking at several years' worth of a company's financials, examining how the company is financing its growth and checking if this growth is sustainable in the long term. This makes for a holistic stock valuation approach.

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