What is the Price to Earnings Growth (PEG) Ratio?
A PEG ratio is a derivative valuation analysis that compares the price earnings ratio to the growth rate of a company. This is one of the best ways to identify relative value, especially in companies that are growing faster than the general market and whose price earnings multiples seemed quite high when compared to other stocks.
For example, if we were to compare a stock that was growing earnings at a rate of 20% a year to a stock that was growing earnings at a rate of 10% a year a logical assessment would suggest that the PE ratios for these stocks would be different because the stock that is growing faster would probably have a higher PE ratio. This is not always true, but in a perfect world it would be and it serves as a great example because although that stock that was growing earnings at a faster rate had a higher PE multiple it does not necessarily mean that the stock had a higher relative valuation.
An observation of the PEG ratio, however, reveals that fact.
Using the example above, if a company has a PE a ratio of 20 and the growth rate of 20% its PEG ratio, which is calculated by dividing the PE multiple by the growth rate, is equal to 1. On the same note, if the company that was growing at 10% had a PE ratio of 10 it also would have a PEG ratio of 1, making it on par with the faster growing company in terms of relative value.
PEG ratios are attractive because we can use them to compare companies that are growing at different rates and they help us determine fair value across different sectors and industries.
However, PEG ratios can also be somewhat misleading when they incorporate forward looking expectations of analysts that extend beyond the next 12 months. We have determined that forward expectations of analysts are reliable about 12 months out, but beyond that they are far less reliable and therefore PEG ratios that are based on growth expectations far into the future should be taken with a grain of salt.
Preferably, we use trailing 12 month PEG ratios because those allow us to see where PEG ratios have been in the past based on trailing 12 month earnings trends and that gives us an indication of where the best times to buy or sell that stock might be. For example, we might find that the best time to buy a particular stock is when it's trailing 12 month PEG ratio is at an extreme level, and we can identify that using our trailing 12 month PEG ratio chart and then anticipate making an investment when we see the PEG ratio for that stock approach our target range again.
