The PEG ratio which is the price/earnings to growth ratio is used to determine the relative trade-off between price of stock, earnings per share (EPS) and the expected growth of the company.
Generally, a company that has a higher rate of growth will have a higher P/E ratio. So, if only the P/E ratio is used for a company which has higher growth rate then it will appear to be overvalued as compared to the others. Therefore, if the P/E ratio is divided by the earnings growth rate then the resulting ratio will be more suitable for comparing different companies having different rates of growth.
The PEG ratio was first developed by Mario Farina in the year 1969. This was mentioned in his book ‘A Beginner’s Guide to Successful Investing in The Stock Market’. However, in 1989, this was made popular by Peter Lynch in his book, ‘One up On Wall Street’, where he wrote that the P/E ratio of a company which is priced fairly will equal its growth rate, which means that the PEG ratio will be equal to 1 for any company that is fairly priced.
Formula of PEG Ratio
PEG ratio = Price / Earnings ÷ Annual EPS Growth
The PEG is commonly used for indicating the possible true value of a stock. PEG ratio is similar to PE ratio in the way that lower ratios of both means undervalued stock. Since PEG takes into account the growth aspect, it is sometimes chosen over the P/E ratio.
When the PEG ratio is 1 then it reflects that the stock is valued reasonably considering the expected growth. When the PEG values are between 0 and 1, then it may give higher returns. The PEG ratio is also sometimes negative. This may happen when there is a possibility of the earnings to decline. The PEG components should be analyzed for devising a successful investment strategy.
Advantage and disadvantage of PEG ratio
The advantage of PEG is that it clearly shows a company’s probable growth in earnings. The disadvantage is that it is not suitable for companies that do not have high growth.