Price/Earnings-to-Growth (PEG) Ratio
Beginner investors find it complex to learn about the stock market and invest based on the gained knowledge and end up investing based on hear-say and intuition. This becomes the main reason for losses and forces them to lose a chunk of their capital. On the contrary, experienced investors swear by evaluating and analysing a stock before taking a trade. They believe that a company is as good as its current value, which is vital to predicting its future growth.
Primarily, these investors use the process of technical analysis to evaluate a stock. However, as there are numerous technical indicators, it is important to learn about each of them to create an effective investing strategy. This blog will detail technical analysis and one of its indicators called Price/ Earnings to Growth ratio (PEG). But before you learn about the indicator, you need to understand two things: Technical Analysis and P/E Ratio.
What is Technical Analysis?
Technical Analysis is the study of chart patterns, graphs and diagrams on a screen. The idea is to understand price and volume trends and pick a specific stock. Technical analysis is based on the premise that historical price trends tend to repeat over time. In technical analysis, you sit with historical stock charts, look at price and volume data, and then plot various trends. Based on past wisdom, you find patterns to trade for the future. One of the most widely used ways to do technical analysis is to look at the past price patterns of the stock and compare them with the present price to understand the stock’s performance and potential.
What is P/E Ratio?
P/E ratio is a technical indicator that measures a company’s per-share price relative to its per-share earnings. High P/E Ratio signals that investors are optimistic about the company’s future earnings and are willing to pay more. It allows investors to understand the growth potential of a company and to determine its relative value.
For instance, if a stock’s PE ratio is 10, it simply means that investors are ready to pay 10x of the company’s earnings to buy it. Furthermore, if a company is not performing well, has no earnings or is in loss, it will not have a P/E ratio. The P/E ratio becomes the base for the calculation of the Price Earnings to growth ratio (PEG), which you can understand by reading below.
What is the Price/Earnings to Growth Ratio (PEG)?
The Price/Earnings to Growth Ratio (PEG) is an extension of the P/E Ratio and is calculated to determine a stock’s value by adding in the company’s expected earnings growth. The investors use the Price/Earnings to Growth Ratio (PEG) to further evaluate and analyse a stock’s value after they have calculated the P/E Ratio for the same stock. When compared to the P/R Ratio, the Price/Earnings to Growth Ratio (PEG) is considered to reflect a stock’s true value better. Similar to the P/E Ratio, a lower value of the Price/Earnings to Growth Ratio (PEG) indicates that the stock is undervalued, and a higher value indicates that the stock may be overvalued.
How to calculate the Price/Earnings to Growth Ratio (PEG)?
You can use the following formula to calculate the Price/Earnings to Growth Ratio (PEG):
PEG = Share Price / Earnings per share (EPS) / Earnings per Share (EPS) growth rate
To calculate the Price/Earnings to Growth Ratio (PEG), you first need to identify or calculate the P/E Ratio and the EPS of the stock. Their formulas are:
- P/E ratio = share price/ EPS
- EPS = Net Income- Preferred Dividends/No. of outstanding shares
Once you have calculated the P/E Ratio and the EPS, you need to find the EPS Growth Rate. You can calculate the EPS Growth rate by subtracting the current year EPS from the prior year’s EPS, dividing the result by the prior year’s EPS and multiplying by 100. You can also go to IIFL’s website and find out the EPS Growth Rates for various stocks to be put in the above formula to calculate the Price/Earnings to Growth Ratio (PEG).
Example of How to use the Price/Earnings to Growth Ratio (PEG)
For a better understanding of how to use the Price/Earnings to Growth Ratio (PEG), consider the following example:
Suppose the stock has a share price of Rs 500. It had an EPS of Rs 5 in 2020 and an EPS of Rs 10 in 2021. From this information, you get the below results:
- Share Price = 500
- EPS = 10
- EPS Growth Rate = 100 ((10-5/5)x100)
- By putting the above values in the Price/Earnings to Growth Ratio (PEG), you get the PEG of the stock as 0.50. Based on this value, you can evaluate the value of the stock and initiate a trade accordingly.
How to trade using the Price/Earnings to Growth Ratio (PEG)?
The main reason investors use the Price/Earnings to Growth Ratio (PEG) is the results it gives compared to the sole use of the P/E Ratio. If you are only using the values of the P/E Ratio, you would want the value to be as low as possible. However, when you add the growth earnings part of the company through the Price/Earnings to Growth Ratio (PEG), you can understand if the stock is undervalued or overvalued effectively. The Price/Earnings to Growth Ratio (PEG) allows investors to factor in the company’s expected growth and adjust the resulting values for companies that have a high P/E Ratio and growth rate.
For example, a Price/Earnings to Growth Ratio (PEG) value of less than one is considered ideal and indicates that the stock is undervalued and can rise in price soon. On the other hand, if a stock has a Price/Earnings to Growth Ratio (PEG) value of more than one, it would indicate that it is overvalued and can fall in price in the coming days.
Based on the Price/Earnings to Growth Ratio (PEG) values, investors can find the ideal entry and exit points for a specific stock. For example, a short term trader may want to invest in a stock that is on the verge of increasing as per its true book value. In such a case, a stock with a Price/Earnings to Growth Ratio (PEG) value of less than one would be ideal. However, it should be noted that the Price/Earnings to Growth Ratio (PEG)’s indication of an undervalued and overvalued stock varies by company type and the industry.
Final Words
The Price/Earnings to Growth Ratio (PEG) is an effective extension of the traditionally used P/E Ratio and allows investors to evaluate stocks in a better way. According to industry-best investors, a company’s expected growth and the P/E should ideally be equal, depicting a fair value of the company and a Price/Earnings to Growth Ratio (PEG) of 1. However, it is always wise to use the Price/Earnings to Growth Ratio (PEG) along with other technical indicators to create a fool-proof strategy that is unlikely to fail.
Related Articles
Frequently Asked Questions
The Price/Earnings to Growth Ratio (PEG) allows investors to identify if the stock is undervalued or overvalued based on its P/E Ratio and expected earnings.
Ideally, a Price/Earnings to Growth Ratio (PEG) of less than one means that the high P/E Ratio of the company is justified by its growth rate. However, if a company has a low P/E Ratio along with a PEG ratio of more than 1, it means that the stock is overvalued, and its growth rate doesn’t justify its high P/E Ratio.
PEG ratio is similar to the P/E Ratio except that PEG factors in the company’s expected earnings growth.