What Is the PEG Ratio?

You’re looking at multiple stocks in the same sector and attempting to compare them to see which company you should invest your hard-earned money in. You begin looking through the list of each company’s key Financial Metrics to find stocks that might be good options. However, with so many financial ratios and other metrics to analyze, it can be hard to know which ones to focus on and why. You’ve heard that a common valuation method is to look at a company’s price-earnings (P/E) ratio, but what about its price-earnings-to-growth ratio?

It’s important to know that calculating the PEG ratio is just one of the many ways you can value a company’s stock. We delve into what this specific ratio indicates, how to calculate PEG ratios, what is a good PEG ratio, as well as some limitations of the PEG ratio.

What Is the PEG Ratio?

The price-earnings-to-growth (PEG) ratio is used to determine a stock’s value by factoring in the company’s historical or forecasted earnings growth. This specific financial metric is a more transparent and accurate indication of a company’s value than the price-earnings ratio because it considers the company’s future growth potential. Just like the price-earnings ratio, a lower PEG ratio may indicate that a stock is undervalued and, vice versa, a high PEG multiple may tip off an investor that the security is overvalued. The PEG ratio is especially useful when evaluating high-growth companies because it offers an idea of whether its rich price-earnings ratio is warranted given its level of earnings growth.

The reason an investor should want to consider a company’s growth compared to its stock price is because a business that’s expected to increase its revenue, earnings and cash flow at a high rate should be valued higher than a similar company with little growth opportunity. Ultimately, the long-term price performance of a stock is determined by the company’s growth prospects.

For this reason, growth companies tend to have higher price-earnings ratios than value companies, which will appeal to different types of investors with alternate goals in mind. When calculating the PEG ratio, you will always use the price-earnings ratio in the formula so it’s important to understand its meaning.

Similarly to other Financial Metrics, the PEG ratio complements the price-earnings ratio when performing an analysis and when comparing multiple stocks to each other. Keep in mind that you should analyze and evaluate multiple key Financial Metrics before choosing to invest in any company.

How to Calculate the PEG Ratio

Understanding how to calculate the PEG ratio as well as breaking down the PEG formula can help you determine if a stock or other security is a good investment for you. The PEG ratio is calculated by dividing a company’s price-earnings ratio by its growth rate in earnings per share:

PEG ratio = (current price ÷ earnings per share) ÷ earnings per share growth rate

If you’re wondering how to calculate the PEG ratio on your own, it’s easy. But first, you will need three key pieces of information that you can find on the AAII website by searching for any stock or other security. These three financials include:

• Stock price,
• Earnings per share and
• Expected or historical earnings growth rate.

In other words, simply find the company’s price-earnings ratio, locate its historical or expected growth rate, then use the PEG formula to arrive at the ratio.

For example, the PEG ratio for Microsoft Corp. (MSFT) is 1.4, calculated by dividing its price-earnings ratio by its five-year historical growth rate. To put this number in perspective, the median PEG ratio for the software industry is 1.9.

For evaluating most stocks, you will want to look at the historical PEG multiple. The historical PEG ratio divides the current price-earnings ratio by the historical growth rate in earnings. It is up to the investor to choose the time frame to use for historical growth, but generally three- to five-year periods are the norm.

How to Analyze Companies With the Price-Earnings-to-Growth Ratio

When evaluating firms that are growing at significantly different rates or at high absolute rates, it is more practical to employ the PEG ratio to consider growth rates. In addition, the PEG multiple can provide you with an idea of whether a high-growth company is worth its rich price-earnings valuation.

Because the PEG formula looks at earnings growth relative to the price-earnings ratio, many investors use this metric to better differentiate stocks and to add an explicit growth element to the basic price-earnings ratio.

As is the case with most ratios used in investment analysis, interpreting the ratios in the real world can be more difficult than calculating them.

Should I Use the Forward or Historical PEG Multiple?

In most scenarios, the PEG ratio is calculated based on the historical growth rate. The time period used is up to the investor, but a three-year or five-year period is common. Forward PEG ratios use expected earnings growth in the calculation. On the AAII website, the historical PEG multiple is reported.

While historical growth rates show companies’ short- and longer-term historical performance, some investors are concerned with future earnings potential instead of past growth. The forward PEG ratio compares the forward price-earnings ratio (current price divided by the consensus earnings per share estimate for the current fiscal year) to an estimated growth rate in earnings per share.

The rationale behind using this ratio is simple—stocks with a high expected growth rate should trade with higher price-earnings ratios than stocks with low expectations for future earnings growth. Once again, there are several time frames that can be used for the expected growth rate figure. Similar to historical PEG ratios, forward PEG ratios may show a large variance depending on the growth rate used in the formula. For example, a different forward PEG ratio will result by using the average growth rate for the past fiscal year and the next two years than would result by using the average earnings growth estimate for the next three to five years.

It is up to the individual investor to decide whether they want to analyze companies based on the historical or forward PEG multiple since each investor has unique goals specific to their strategy and needs.

Adjusting the PEG Ratio for Dividends

Often, especially in value investing, there are large and highly profitable companies that return a lot of their earnings to shareholders in the form of cash dividends. These companies may be growing slowly and therefore appear to be significantly overvalued. However, in addition to earnings growth driving share prices, shareholders get a sizable dividend on a regular basis. These dividends are a form of return and the normal PEG ratios do not take into account the dividend these companies pay, placing them at a disadvantage. In these cases, an adjustment can be made to the PEG multiple to “level the playing field” between these types of stocks and non-dividend-paying stocks. The dividend-adjusted PEG ratio is calculated as follows:

Dividend-adjusted PEG ratio = price-earnings ratio ÷ (earnings growth rate + dividend yield)

Once again, there are two different dividend-adjusted PEG ratios that are often used by investors. The historical dividend-adjusted price-earnings-to-growth ratio uses the historical price-earnings ratio and earnings growth rate, while the forward dividend-adjusted PEG ratio uses the forward price-earnings ratio and an estimated earnings growth rate.

Limitations of Using the PEG Multiple

The PEG multiple has often been used to value companies with high levels of growth. One of the reasons for its use was for analysts and investors to determine whether a fast-growing company deserves a high price-earnings ratio. However, this ratio, and even the dividend-adjusted PEG ratio, may not be appropriate for large, mature companies that pay a large portion of earnings in the form of dividends.

The PEG formula also uses earnings per share growth rates. The historical growth rate is easy enough to calculate with accuracy, but the growth estimate depends on analysts and these figures can be highly inaccurate or hard to find, especially for smaller or less-followed companies.

In addition, there is no consensus on the time frame that should be used for the growth rate. Appropriate time frames will be different for cyclical and non-cyclical companies. Usually, five years is a common look-back period for historical growth, while projected earnings growth may look forward three to five years.

What Is a Good PEG Ratio?

The definition of a “good” versus a “bad” PEG ratio is a bit up to the interpretation of the individual investor. Generally, a PEG value of 1.00 represents a perfect correlation between the company’s overall market valuation and its earnings growth. PEG ratios of more than 1.00 may indicate that the company is overvalued. However, it’s important to review other Financial Metrics to ensure this is the case. On the other hand, PEG ratios lower than 1.00 may indicate that a stock is undervalued.

You can also look at the industry median of price-earnings-to-growth ratio to evaluate a company’s valuation relative to its peers.

If you are looking for low PEG ratio stocks, AAII has specific screens you can use to find qualified companies that fit that criterion. One particular screen to identify low PEG ratio stocks is our Value On the Move PEG With Estimated Growth screen. A few companies that are passing the low PEG ratio stock screen include:

• Penske Automotive Group Inc. (PAG)
• Toll Brothers Inc. (TOL)
• Heritage-Crystal Clean Inc. (HCCI)
• Hess Midstream LP (HESM)
• Flex Ltd. (FLEX)

You can review the above stocks and others that pass the screen on the AAII website, as well as add any of the stocks to one of your portfolios in My Portfolio to monitor and track them over time.

What Does a Negative PEG Ratio Indicate?

In some cases, you may see a negative PEG ratio when you are researching a security. A negative PEG ratio may occur if a stock has negative earnings or if future earnings are expected to decline, indicating negative growth. On AAII.com, companies with a negative PEG ratio will show a null, or invalid, symbol.

You may be concerned if the company is showing negative earnings, but don’t completely write off the business yet. The best practice for investors who see a negative PEG ratio due to negative earnings is to evaluate whether the company is facing temporary or permanent problems that may potentially impact its overall growth and earnings in the long term.

A negative PEG ratio due to declining growth is a bit less serious. Even the strongest companies in each industry can see decreasing or negative growth in their earnings during market fluctuation and volatility. Before investing in a company, you should look at the historical data to evaluate whether earnings growth has been declining over time or has just hit a rough patch.

If the company consistently has had a negative PEG ratio, you may want to look elsewhere.

What Types of Investors Use the PEG Ratio?

Both value and growth investors can use the PEG ratio to isolate investment candidates. Although value investors may tend to rely on the price-earnings ratio more often, using it in conjunction with the PEG ratio will help them understand the company’s potential for growth in relation to its price and overall earnings.

On the other hand, growth investors may look at the PEG ratio because they want to make sure that the company they are investing in is fairly valued in relation to its growth prospects.

Value and growth investors alike will want to look at multiple Financial Metrics before deciding whether to buy or avoid a stock.

Using the PEG Ratio to Invest

With AAII’s Stock Investor Pro fundamental stock screening and research database software and the Custom Stock Screener in AAII’s A+ Investor online investment suite, you can screen for stocks based on the PEG ratio.

AAII has screens to find low PEG ratio stocks that also consider industry factors and seek companies with additional criteria. For individual investors, the idea is to purchase a stock with some demonstrated earnings growth at a discount to the price-earnings ratio before the market recognizes the company’s potential and bids up the PEG ratio.

Simple screens for low price-earnings ratio stocks without additional qualifiers typically turn up a list of troubled stocks. It is not uncommon to see firms in dying industries, companies on the brink of insolvency, or even companies facing potentially devastating litigation pass low price-earnings screens. That’s why you may want to investigate AAII screens that consider the PEG multiple as well as the price-earnings ratio. While firms with high price-earnings ratios normally have everything going for them now, the PEG formula helps investors judge whether the market is overpaying for these stocks and what the overall sentiment is.

Remember, it is important to perform additional due diligence to verify the financial strength of passing companies and identify those stocks that match your investing tolerances and constraints before committing your investment dollars. Check out Stock Investor Pro or A+ Investor to screen for low PEG ratio stocks to invest in.