# Price Earnings to Growth (PEG) Ratio - Explained

What is the PEG Ratio?

# What is the Price Earnings-to-Growth Ratio?

The PEG ratio is a metric used to determine the trade-off between the stock's price, the earnings it will generate, and the growth rate expected by the company. If a company has a high growth rate, then it is expected that the price/earnings ratio will also be high. Therefore, the use of P/E ratios alone would make the companies with high growth rates appear overvalued. When the P/E ratio is divided by the company's growth rate, it provides a better comparison for the different growth rates.

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## How Does the PEG Ratio Work?

PEG ratio is an improved type of the P/E ratio as it factors in the growth earnings of a company. Investors and analysts make use of price/earnings to growth ratio to value a company's shares. It also helps them know the growth history of the company over time. Investors are likely to invest in companies with high PEG ratios because they expect higher growth rates in the future.

## Calculating the PEG Ratio

PEG Ratio = (Stock's price divided by EPS). You divide this by the growth rate of the earnings. EPS refers to Earnings per share. For an investor to calculate the PEG ratio, he first needs to calculate the P/E ratio. The accuracy of any ratio is dependent on the type of inputs used, and the accuracy of the PEG ratio. It is always important to find the growth rate used for a certain PEG calculation. Some websites provide information on the growth rates of stocks. An example is Yahoo! Finance, which uses the current year's data and an expected 5-year growth rate to calculate PEG. This will provide a more accurate PEG than using past growth rates. The terms forward PEG and trailing PEG are used to differentiate growth rate calculations. Forward price to earnings uses indicators based on future earnings of the company. This gives a clear picture of what the investors should expect in the future. Trailing price to earnings, on the other hand, uses indicators from the past 12 months to calculate the PEG ratio.

## An example of PEG Ratio calculation

Take an example of the stock of Company ABC. Assume ABC is doing business with a price/earnings ratio of 30. Many investors will consider this a costly stock. But, we can also assume that the analysts have predicted a growth rate of +40% per share in the coming year. Here, the PEG ratio of Company ABC would be; PEG ratio = 30 / +40 % (growth earnings) which is equal to 0.75 A PEG ratio that is lower than 1 is well-thought-out as a good value. The P/E value for ABC is high. But, according to its PEG ratio, it has been undervalued as it has high growth potential.

## A good PEG Ratio

Investors and analysts make use of the PEG ratio to assess the performance of a company and evaluate the risks associated with an investment. Any PEG ratio with a value 1 indicates that the market value and earnings growth of the company have a perfect connection. PEG ratio that is higher than 1 indicates that the stock has been overrated and is unfavorable in the market. On the other hand, PEG values less than 1 show that the stock has been under-priced. They are considered a better option than high PEG ratio values. There are cases where the PEG ratio may have a negative value. This can happen when;

• In the past years, the company had lost a significant amount of money.
• The company is making profits, but the profits are going to reduce drastically in the future.

It is important to note that a negative PEG ratio, does not mean that investing in the stock is a bad idea. It simply requires an investor to first analyze the stock critically before making the final decision.

## Uses of PEG ratio

Used to determine the stock value depending on the growth patterns of the company. The prices of a stock are inclined to demand, speculation, and investor expectations. PEG ratio helps analysts to value a company depending on its products and adjust its value so that it can keep growing. There isn't a standard for measuring an investment as different companies have varying growth rate earnings.