What is the Price/Earnings to Growth (PEG) Ratio?

The PEG ratio is a company’s Price/Earnings ratio divided by its earnings growth rate over a period of time. The PEG ratio adjusts the traditional P/E ratio by taking into account the growth rate in earnings per share that are expected in the future. This can help “adjust” companies that have a high growth rate and a high price to earnings ratio.

In other words, it allows investors an idea about a stock’s actual value like a P/E ratio does while also factoring in its growth potential. Therefore, for more fundamental analysis, the PEG ratio is crucial.

How to Calculate?

As stated earlier, it denotes the ratio between a stock’s P/E ratio and its projected growth in earnings. It is noted that the P/E ratio, thus considered for PEG ratio is the trailing version and not the forward P/E ratio.

And the PEG ratio formula is written as,
Price/earnings-to-growth = (Market price of stocks per share/EPS) / Earnings per share growth rate

Example: Company QWE recorded earnings worth of Rs.12 lakh in FY 2019 – 2020. The market price of its share at that time was Rs.10, and it had a total of 150,000 outstanding shares. Its EPS recorded a 2% growth over the last year and is projected to grow by 2.5% for the next year.

Therefore, its EPS, as per the records of FY 20 – 21, is Rs. 8 (1200000 / 150000).
P/E ratio = 10 / 8 = 1.25

Hence, PEG ratio = 1.25 / 2.5 = 0.5

Interpreting the PEG ratio

A stock with a very high P/E might be viewed as overvalued and not a good choice. Calculating the PEG ratio on that same stock, assuming it has good growth estimates, can actually yield a lower number, indicating that the stock may still be a good buy.

The opposite holds true as well. If you have a stock with a very low P/E you might logically assume that it is undervalued. However, if the company does not have earnings growth projected to increase substantially, you may get a PEG ratio that is, in fact, high, indicating that you should pass on buying the stock.