Financial Statement Analysis - PEG (Price/Earnings to Growth) Ratio

This accounting ratio illustrates the relationship between stock price, earning per share, and an organization's expected growth rate. It is often used in management discussions, especially those where strategic growth is being considered.

PEG is a widely used indicator of a stock's potential value. Many people favor it over the price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.

The PEG (Price/Earnings to Growth) Ratio

The PEG ratio is calculated by dividing the Price to Earnings (P/E) ratio by an organization's annual EPS (Earnings per Share) growth. The growth rate is expressed as a percentage, and should use real growth only, to correct for inflation.

For example, if an organization is growing annually at 30% and has a P/E of 30 then its PEG would be '1.'

It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

In general, the P/E ratio is higher for a company with a higher growth rate. Using just the P/E ratio would make high-growth companies appear overvalued relative to others and this is why the PEG ratio is more widely used.

A lower ratio is cheaper and a higher ratio is more expensive. For example, it is considered that an organization with:

• PEG < 1 is undervalued
• PEG around 1 is fairly valued
• PEG > 1 is overvalued.

The P/E ratio used in the calculation may be projected or trailing, and the annual growth rate may be the expected growth rate for the next year or the next five years.

Example PEG ratios

There are many variations using earnings from different time periods (for example, one year versus five years) and you should be clear about which one your source is using so that you can make valid comparisons.

By comparing two stocks using the PEG, you can see how much you're paying for growth in each case.

A PEG of 1 - means you're breaking even if growth continues as it has in the past.
A PEG of 2 - means you're paying twice as much for projected growth when compared to a stock with a PEG of 1.

This is speculative because there is no guarantee that growth will continue as it has in the past. The P/E ratio is a snapshot of where an organization is and the PEG ratio is a graph plotting where it has been.

Comparing P/E and PEG ratios

Armed with this information, an investor or a management team has to decide whether the organization is likely to continue in it's present direction. Management have to assess whether their current strategy needs to be altered in order to maintain their desired growth.

This Key Financial Ratios Checklist details the key financial ratios you can use to help you interpret financial information. This Financial Ratio Formulas Checklist provides you with a list of the most popular financial ratios used to assess an organization's performance, solvency, profitability and investment potential. If you need a basic financial accounting principles pdf then download our free eBook now.

You may also be interested in:
Financial Statement Analysis | Key Accounting Ratios | Types of Key Accounting Ratios | Current Ratio Analysis | Calculating Profit | Business Performance Ratios | Price/Earnings Ratios | Price-to-Book Ratio | Dividend Yield.

Key Points

  • The PEG (Price/earnings to growth) ratio illustrates the relationship between stock price, earning per share, and an organization's expected growth rate.
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