The PEG ratio is a comparison between the price of a stock, a stock's P/E and the expected EPS yearly growth.
To calculate PEG: PEG = (price / annual earnings) / (% annual growth)
What are the accepted values for PEG?
Generally, values of greater than 1 show that the company is possibly overvalued or expects that the companies future earnings per share growth will be higher than the market estimates (growth stock). With PEG values of less than 1 means that the company may be undervalued or that the companies future earnings per share growth will be lower than the market estimates.
Problems with PEG:
1) PEG ratios work best with growth companies. Income stocks/companies are generally well established and offer less growth opportunities.
2) The growth estimate is exactly that, an estimate. It could change.
3) PEG values (ie greater than or less than 1) are rules of thumb not absolutes.
4) PEG does not account for inflation. IE with PEG if a company grows at the same speed as inflation the PEG may have a number but it's rather meaningless since in reality there is no growth.
5) PEG should be used as a description of the growth to price trade/off, not as an absolute.
6) PEG ratios should not be used as the only valuation method since ratios are only as reliable as the data on which they are based. PEG ratio's should therefore be supplemented with other complementary methods to achieve a reasonable opinion.
7) PEG ratios with low growth companies generate rather nonsensical values.
8) Companies with zero growth cannot be calculated with PEG (divide by zero).
Why use PEG?
PEG gives a relative value for a companies stock price based on future growth. Tends to work well with companies that are in the growth stage of their life cycle.
Example calculation:
Company XYZ trades at 20$
Current (last reported EPS) is 1$ per share
Future (estimated) EPS is $1.25 per share
Company XYZ is expected to have a 25% earnings growth (1.25/1 = 1.25 or 25% positive growth)
Current P/E on estimated EPS = 20 / 1.25 = 16
PEG of company XYZ = 25 / 16 = 1.5625
Note: Ratios should not be used as the only valuation method since ratios are only as reliable as the data on which they are based. Ratio's should therefore be supplemented with other complementary methods to achieve a reasonable opinion.
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