PEG ratio or Price/Earnings to Growth Ratio is a simple valuation ratio that helps you determine whether a stock is undervalued or overvalued. It is calculated by dividing the Price to Earnings ratio by the Growth rate. The growth rate here refers to the Profit growth rate. Some analysts and websites also take growth rates as Earnings growth rate.
PEG ratio=Price to Earnings ratio/ Profit growth rate
Before we understand the PEG ratio, let us understand what we mean by the P/E ratio and Profit growth rate.
The P/E ratio tells us how many times the Earnings per share the investors are ready to pay to buy a share of the company, and the Profit growth rate tells us how much growth has been there in a company’s profit in percentage terms.
Let us consider an example:
Company A share price is trading at Rs. 900. Its Earnings per share is 60. What is its P/E?
Ans. P/E= Current share price/ Earnings per share
i.e. 900/60= 15
It means that the investors are ready to pay 15 times the earnings per share (EPS) to acquire one company’s share. Is the share price high?
We can’t say whether the share price is high or not with the P/E ratio only, and there is no mathematical formula that says a P/E of a particular value is fair or good. We have to compare the P/E ratio with something else to determine whether the share price is high or not.
- Compare the P/E ratio of the company with its peers.
- Compare the P/E ratio of the company with the industry P/E.
- Compare the P/E ratio of the company with its growth.
Interpretation of PEG Ratio
PEG ratio tells us that the company’s P/E should not be more than its profit growth rate. When we compare the profit growth rate, ideally, we take the profit growth rate of 3 or 5 years. PEG should not be more than 1. If it is more than 1, the company is overvalued, and if it is less than 1, the company is fairly valued or slightly undervalued. But it does not mean that we go and buy the stock blindly. It is one of the valuation methods; we have to check other valuation methods also.
Case 1: Company A
Let us assume,
P/E of company A= 33.05
1-year profit growth= 75.5%
3-year profit growth= 34.39%
5-year profit growth= 25.44%
If we compare with 3 years profit growth, PEG = 33.05/34.39= 0.96
If we compare with 5 yeas profit growth, PEG= 33.05/25.44= 1.3
In both cases, the company is slightly fairly valued according to the PEG ratio. We have to take this ratio for companies whose earnings are stable and regularly grow like FMCG, Pharmaceuticals, and IT.
Case 2: Company B
Let us assume,
P/E of company B= 9.01
1-year profit growth= 4.56%
3-year profit growth= 4.53%
5-year profit growth= 8.49%
If we compare with 3 years profit growth, PEG = 9.01/4.53= 2
If we compare with 5 yeas profit growth, PEG= 9.01/8.49= 1.1
In the first case, the stock is expensive, and in the second case, the stock is fairly valued. If there is any such confusion, then see what the latest trend is. Last year also saw a 4.56% profit growth. In such a situation, we have to give more weightage to the 3 years’ data because it is very close to the latest trend, i.e., 1-year data and the profit growth are decreasing compared to the last 5 years data. In Case 1, we have to give more weightage to 3 years because the profit growth is consistently increasing in these 5 years. Recent 1-year data helps us to decide whether to give more weightage to 3 years or 5 years.
Note: Profit growth is readily available on the website www.screener.in
Limitations of PEG ratio:
- The growth forecast may be wrong.
- The past growth may or may not be sustained in the future.
- The PEG ratio doesn’t consider dividends.
- It is not a good metric for asset-heavy businesses like Real estate, Telecom, etc.