PEG Payback Period - Explained
What is a PEG Payback Period?
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Table of ContentsWhat is a PEG Payback Period?How Does a PEG Payback Period Work?Drawbacks of the PEG Ratio
What is a PEG Payback Period?
The PEG (Price to Earnings Growth) payback period refers to a key ratio that is utilized to ascertain how long it will take for an investor to double his or her money with a stock investment. The price-to-earnings-growth payback period is the period it would take for the earnings of a company to equate the stock price which the investor paid. The PEG ratio of a company is used instead of its price-to-earnings ratio in that it's assumed that the earnings of a company would rise eventually. Theoretically speaking, the earnings or price to growth ratio helps analysts and investors ascertain the relative trade-off between a stock's price, the stock's earnings per share (EPS), and also the expected growth rate of the company.
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How Does a PEG Payback Period Work?
The perfect reason to calculate the PEG payback period is to ascertain how risky an investment is. As a measure of relative riskiness, the primary benefit of the PEG payback period is as a liquidity measure. Liquid securities and investments are usually termed less risky than illiquid variations; all else held constant. Usually, the longer the time of payback, the riskier an investment becomes. The reason for this is that the payback period depends on the analysis of the earning potential of a company. It is more difficult to predict such potential further into the future, and eventually, there's a greater risk which those returns won't be actualized.
Drawbacks of the PEG Ratio
One of the PEG ratio's major deficiency is that it is largely an approximation; a deficiency that is specifically subject to financial engineering or manipulation. Irrespective, the PEG ratio, as well as, resulting PEG payback period still benefit from the vast use in the financial press and also within the reporting and analysis by capital market strategists. The growth rate utilized in the PEG ratio is usually derived in a way or two. The first method makes use of forward-looking growth rate for a company. This number will be a yearly growth rate (i.e. percentage earnings per year), covering up to five years. The other method utilized a trailing growth rate gotten from a trailing financial period, like the past 12 months or the last fiscal year. A multi-year historical average might be perfect as well. Selecting a trailing or forward growth rate is dependent upon the most realistic method for future project results. For some developed businesses, a trailing rate might be a reliable proxy. For high growth or businesses having a new product, a growth rate that's forward-looking might be preferred.