Education: Value Investing

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Understanding Price/Earnings-to-Growth (PEG)

Would you like to learn about an often neglected tool that can aid in your search for undervalued stocks?

While it may not be as frequently used or cited as the ever-so-popular price-to-earnings ratio (P/E ratio), the price/earnings to growth ratio (PEG ratio) can be extremely useful. It is important to keep in mind that the P/E ratio by no means perfect. The PEG ratio was created to combat the limitations associated with the P/E ratio.

P/E Is Not King

While the P/E ratio is certainly a data point to consider, it is somewhat limited. The P/E ratio is calculated as follows:

P/E Ratio = Price per Share/Earnings per Share (EPS)

The key point to consider here is that the EPS figure used in the above equation is typically the last 12 months earnings of the company. Therefore, the P/E ratio is only taking the past into consideration. But what about the future? Investors should be truly concerned about a company’s projected earnings growth. How many times have you read the disclaimer: Past performance is not indicative of future performance? I think you get the point.

We will dive into the P/E ratio at greater lengths in an article devoted solely to that particular measure. For now, let’s move on to see how the PEG ratio works to rectify this limitation.

A New Ratio Is Born

The relationship between the price/earnings ratio and the projected earnings growth of a company is called the PEG ratio and is calculated as follows:

PEG ratio = Price-to-Earnings Ratio/Earnings per Share Growth

How does one interpret the PEG ratios of various companies? It is actually quite simple. Typically, the lower the PEG ratio, the more undervalued a stock is. Here is a quick and dirty thumbnail guide to PEG ratios:

Undervalued: PEG less than 1.0

Analysts are more enthused about the company’s growth prospects than the market is. If a stock's earnings expectations have recently risen but the market has been oblivious to such growth, this can lead to a PEG ratio of less than one.

Fair Valued: PEG equal to 1.0

The market is pricing the stock to fully reflect the stock's EPS growth.

Overvalued: PEG greater than 1.0

The market expects future EPS growth to be greater than what is currently in the Street consensus number. Investors are willing to pay more for a stock that is expected to grow rapidly.

Confused? Well, don’t be. An example should help clear things up.

PEG Calculation Example

VanDeleigh Industries (fictitious company)

Current stock price: $20 per share

P/E ratio using the current year’s estimate: 12.97

EPS growth rate over the next 3-5 years: 13.5%

PEG ratio: 12.97/13.5 = 0.96

In the above example, the figure used for VanDeleigh’s earnings per share growth was the company’s forecasted growth rate over the next 3-5 years. This is typically the case; however, please keep in mind that the number used for the annual growth rate can vary from a forecasted to even a historical figure. Furthermore, the number of years can also vary.

Based on the easy-to-use thumbnail guide discussed earlier, a PEG of 0.96 would represent an undervalued stock. However, this figure should also be compared to the PEG of the market and to the industry in which VanDeleigh participates.

Let’s assume the PEG ratio for the market, represented by the S&P 500, is 3.0 and the PEG of the industry stands at 1.4. These figures are both larger than 0.96—that is good news. Why? Because the market expects more out of VanDeleigh’s industry and will pay more for its potential growth than it will for VanDeleigh itself.

In a nutshell, the market is not expecting much from VanDeleigh Industries. Does this represent a buying opportunity? Only if the PEG ratio was a perfect stand-alone measure…

Is the PEG Ratio Perfect?

If any one ratio was void of limitations, why would others exist? Similar to the P/E ratio, the PEG ratio has its shortcomings as well.

1) The ratio is based on projected earnings per share growth. Projections are not always accurate—just ask Cubs fans: “This is our year…”

2) PEG ratios are considered less useful in assessing cyclical stocks. Profits and share prices of cyclical companies tend to follow the ups and downs of the economy. Earnings of these companies can be extremely erratic.

However, the PEG ratio still does a really good job of identifying stocks that are worthy of further study. When a PEG ratio is used with other measures it can be extremely valuable.

Earnings Estimate Revisions and the Zacks Rank

It is imperative that you don’t peg all your hopes on low PEG ratios. Investors should never use any tool as a one-stop decision maker to uncover stocks that are potentially undervalued. When the PEG ratio is used in conjunction with earnings estimate revisions and the Zacks Rank, now we’re talking.

When a flurry of analysts is submitting positive revisions to their earnings estimates for a particular company, they are doing so for a reason. Something has caused these analysts to have a more favorable outlook on the company in which they are covering. Earnings estimate revisions have a tremendous impact on stock prices. Remember, earnings estimates are the single best gauge of the future prospects of a company, and the best way to harness this phenomenon is through the Zacks Rank. (Learn more about the Zacks Rank).

Value investors should view this particular stock as currently undervalued relative to its future prospects. Rarely will a stock suffer a significant price decline in the face of improving fundamentals. Combine positive earnings estimate revisions and a healthy Zacks Rank with a PEG ratio of less than 1.0 and you have the next best combination to peanut butter and jelly.