What is the PEG Ratio?
The PEG ratio, or price-earnings-to-growth ratio, is the ratio of a company’s price to earnings ratio (P/E ratio) to the company’s forward projected earnings per share (EPS) growth rate.
While the P/E ratio essentially tells investors how much money people are willing to pay for a stock today based on its past or future EPS, the PEG takes this a step further by putting the projected growth rate of the company’s earnings in the denominator. The PEG ratio, compared to other market multiple ratios, is considered a better indicator of a stock’s possible true value. Similarly, to the P/E ratio, a lower PEG ratio likely means that the stock is undervalued, while a higher PEG means the stock is possibly overvalued.
- The PEG ratio is an extension of the P/E ratio, and is another quick way for investors to determine the value of a stock by accounting for projected earnings growth.
- The PEG ratio takes into account a stock’s price, a stock’s earnings, AND a stock’s projected EPS growth rate. Neither the P/B or P/S ratio consider a stock’s earnings or its forecasted growth.
- A PEG ratio of 1 in theory represents a fair value and perfect correlation between a company’s stock price and its projected earnings growth. PEG ratios over 1 are generally considered overvalued, and PEG ratios between 0 and 1 may offer opportunities for higher returns.
PEG Ratio Formula
The PEG ratio is calculated using the following formula:
PEG Ratio = (P/E Ratio) / Forecasted EPS Growth
P/E Ratio = Current Price Per Share / Earnings Per Share
- Current Price Per Share: The current price per share is the most recent price that a stock has traded at and is not a fixed price. It is driven by market forces, and is consistently fluctuating throughout the trading day. Earnings per share, or EPS, is the value of earnings per a company’s outstanding shares. It shows how much money a company earns per share of their stock.
- Forecasted EPS Growth: This refers to the forecasted growth of a company’s EPS in future periods. This is always expressed as a percentage and is a rolling 12 month forecasted number based on the estimates of analysts. It weights this current year and next year’s earnings forecasts depending on where a company stands in its current fiscal year.
How to Calculate the PEG Ratio Using Financial Data
It is impossible to calculate a company’s PEG ratio exclusively from their income statement. That is because we still need the company’s current price per share, as well as its forecasted EPS growth rate. However, when computing a ratio such as the PEG ratio with so many moving parts, and different data from different sources, the best way to do it is to find a reliable source you trust, and simply get the data from there. While a company’s financial statements are crucial to analyze, these statements are only released quarterly. For the most up to date data, it is often best to simply go off of what sources such as Yahoo! Finance are saying in order to calculate ratios such as the PEG ratio.
Say we wanted to calculate the PEG ratio for a company that is considered high growth, such as Etsy (ETSY). Etsy is an e-commerce platform for artists and creators, and has been one of the biggest winners during the COVID-19 pandemic. According to Yahoo! Finance their P/E ratio (TTM) currently stands at 96.53.
This P/E ratio is relatively high and indicates that Etsy is currently trading at 96.53 times its earnings. This means that investors are willing to pay 96.53 times what ETSY is earning per share. Many would consider this overvalued. Others would say that this is the price you have to pay to invest in growth potential.
Additionally, According to Yahoo! Finance, based on analyst projections, Etsy’s 5 year EPS growth rate is 57.05%.
Now that we have both these ratios we can calculate the PEG ratio for ETSY:
PEG Ratio = 96.53 / 57.05 = 1.69
The PEG compares a company’s P/E to its growth rate, and tells a more comprehensive story than the P/E ratio alone. A PEG ratio tells investors how much they are willing to pay per each unit of earnings growth. As previously said, a PEG ratio of 1 indicates fair value, while a PEG ratio greater than 1 indicates possible overvaluation.
While the PEG ratio which we’ve calculated here is a better indicator of ETSY trading at fair value it still indicates a stock that is trading at a slightly overstretched valuation. Usually the stocks that offer the best returns have a PEG between 0 and 1.
What is a Good PEG Ratio?
Deciding if a P/E ratio is “good” is or “bad” is largely subjective. However, PEG ratio is different. It’s relatively clear cut, and more conclusive. It’s pretty simple really. A PEG ratio essentially tells investors how much they are willing to pay per each unit of earnings growth. A PEG ratio in 1 in theory represents a fair value and perfect correlation between a company’s stock price and its projected earnings growth. PEG ratios over 1 are generally considered overvalued, and PEG ratios between 0 and 1 usually offer the best opportunities for higher returns.
A PEG Ratio is “bad” if it’s negative. A negative PEG shows that a stock has negative earnings or forecasted negative earnings growth. Negative PEG ratios are also usually considered worthless or as an indicator of a risky investment.
While PEG ratios can fluctuate between different sources for various reasons, it’s still always good to compare ratios from company to company, and to the larger sector in which it operates. While the data we have for ETSY’s PEG ratio may be more up to date than what is posted on finance sites, and comparing what we calculated to other company’s PEG ratios may show an imbalance between real time data and trailing data, it’s still good to take a look at the comparisons.
|Ali Baba (BABA)||1.41|
|Walmart Inc. (WMT)||4.19|
One can interpret this a few ways. On one hand Etsy is trading in the middle of the pack compared to the services industry, and compared to other e-commerce retailers. Walmart, while not exclusively e-commerce, is building their e-commerce platform, and is trading with a PEG ratio that indicates overvaluation. A PEG ratio over 1 is considered overvalued. A PEG ratio over 4 indicates a company where investors will pay 4 times more then each unit of earnings growth – which is exceptionally high. On the other side, a company like Ebay, which has a PEG ratio of .86, indicates a company that is undervalued, and a company that investors are not paying a lot relative to each unit of earnings growth. Usually stocks between 0-1 have the most upside, and are considered the most undervalued.
It’s always important however to judge a stock’s PEG ratio based on the broader sector it’s trading in. The services industry, which is the broader sector that ETSY is trading in, has a PEG ratio of 2.02 based on data. Etsy’s PEG ratio of 1.69 is lower than this, which means that although it is over 1, has more fair value than the sector, and has more potential upside than the sector. But again- this is comparing ETSY’s most recent data to data that may not be as up to date.
All of the following reasons might lead to some issues when interpreting the PEG ratio:
- Inconsistent Data: As demonstrated in this report, PEG data can fluctuate between sources, and may not necessarily be universal. The growth rate is largely based on speculation from different analysts. P/E ratios may also not be uniform as quoted from different financial websites. This can cause challenges when comparing companies as you may have more updated info for one company versus older info from another.
- Subjective Interpretation: Much like the P/E ratio, this is not a ratio based off of the actual balance sheet of a company, nor is it based exclusively off their income statement or cash flow. In fact, it’s even more subjective than the P/E ratio, because it’s based on the opinions of different analysts and what they think a company’s growth prospects would be.
- Not as Useful When Evaluating Mature Companies: When evaluating mature companies that pay dividends, rather than reinvesting profits into growth, the PEG ratio can be less uesful. The PEG ratio has severe limitations when measuring companies with low growth. For example, if there is a mature company that is forecasted to grow its earnings at 1% over the next 5 years, it will not have a PEG ratio close to 1. However, it may pay significant dividends and be attractive to investors regardless.
Comparing PEG Ratios of Etsy (ETSY), Chevron (CVX), and Marriott (MAR)
To see how to understand the PEG ratio in practice, consider the PEG of a growth stock like Etsy (ETSY), an underperforming energy stock such as Chevron (CVX), and a struggling hotel company such as Marriott (MAR).
These companies are in very different industries, and are very different stocks. One is a stock with robust growth, the other is a mature energy company with more of a focus on maintaining its dividend than investing in growth, and the other is somewhere in between and has struggled due to COVID-19. This will illustrate the differences in PEG ratios between considerably different companies, and expose some of the limitations of the ratio.
|Chevron Corporation (CVX)||.64|
|Marriott International, Inc. (MAR)||4.23|
How is this to be interpreted? It really does not tell us much. While Chevron has a PEG ratio of .64 indicating that it is undervalued, and that investors are not paying a lot relative to each unit of earnings growth, Marriott’s PEG is over 4 indicating the exact opposite. This is likely due to the low expected earnings growth over the next few years due to COVID-19.
Etsy is in the middle between these two, despite the fact that it has a 5 year EPS growth estimate of 57.05%, compared to Chevron’s negative 5 year EPS growth estimate of -3.73% and Marriott’s negative 5 year growth estimate of -6.72%. This is why this ratio can be very ambiguous, inconsistent, and difficult to interpret.
PEG Ratio vs. Price to Book Ratio
The first ratio we can compare the PEG ratio to is the P/B ratio, or the Price-to-Book ratio.
The P/B ratio is calculated using the following formula:
P/B Ratio = Current Price Per Share / Book Value Per Share
- Current Price Per Share: The most recent closing price for a stock.
- Book Value Per Share: The Book Value Per Share takes a company’s common equity and divides it by its number of shares outstanding. This value essentially indicates a company’s net asset value (total assets-total liabilities) on a per-share basis.
While the PEG ratio is preferred by growth investors, the P/B ratio is strongly preferred by conservative investors. Additionally, while the PEG ratio is of minimal use when evaluating mature companies, the P/B ratio is the opposite. The P/B ratio offers a more tangible valuation of a company than their earnings, however, it does not work well with growth companies.
While the P/B ratio gives investors a better idea of the types of assets behind a certain stock, it does not work well for asset light industries such as tech companies. The PEG ratio serves a different purpose than the P/B ratio. While often both ratios are important to analyze together in order to take an accurate picture of a company’s value and financial health, this is not always the case. It’s important to understand the type of company that is being researched when using each of these ratios.
PEG Ratio vs. P/S Ratio
The next ratio we can compare the PEG ratio to is the P/S ratio, or the Price-to-Sales ratio.
The general formula for the P/S ratio is as follows:
P/S Ratio = Current Price Per Share / Sales Per Share
- Current Price Per Share: Most recent closing price for a stock.
- Sales Per Share: The amount of revenue a company makes per share. It’s calculated by dividing a company’s revenue by the total number of shares outstanding. Revenue and shares outstanding have to be from the same period when calculating this ratio – either quarterly or annually.
While the P/S ratio is advantageous in that you can still calculate it even if companies are not profitable and operating at a loss, this ratio is more easily manipulated and misleading. Simply put, this is not a comprehensive ratio. Depending on how profitable a company truly is, their sales could be worth a little or a lot. For example, a company could be making billions in sales, yet lose money on every transaction – but the P/S ratio would give you minimal insight in this situation.
(P/E Ratio)/Forecasted EPS Growth
|An extension of the P/E ratio. Simple snapshot of a company’s valuation, and more comprehensive because it takes into account growth. |
Better metric than other market multiple ratios to find a company’s true value
|May not be universal between sources. The growth rate is largely speculative, and P/E ratios may not be uniform between past, current, and future metrics.|
Not as useful when evaluating dividend paying companies such as utilities with little forecasted growth.
|P/B Ratio |
Current Price Per Share/Book Value Per Share
|Best ratio for conservative investors – offers a more tangible valuation of a company than their earnings.|
Gives investors a clearer picture of the types of assets behind stocks.
|Useless when evaluating growth companies with little assets such as tech companies. |
Can be especially difficult when comparing or evaluating companies that adhere to different accounting standards- ie. international companies.
|P/S Ratio |
Current Price Per Share/Sales Per Share
|Quick and easy snapshot in comparing companies within the same industry. |
Can still calculate it even if a company is not profitable
|Largely ignores company profitability. Is not comprehensive enough to be an acceptable standalone ratio. |
Does not explain the true worth of a company’s sales.
Drawbacks to Market Multiple Ratios
While market multiple ratios are a good way to take a snapshot of a company’s valuation, there are several serious flaws and drawbacks to consider before putting too much stock and emphasis into these ratios.
- Difficult to Compare Companies in Different Sectors: Like any other ratio, market multiple ratios are only truly effective and comprehensive when comparing companies within the same industry. Different companies in different industries have different growth prospects, different balance sheets, different income statements, and different revenue streams. How can we compare the Price to Book ratio between JP Morgan and Salesforce for example, when JP Morgan has countless assets and Salesforce doesn’t? What is the point in comparing JP Morgan and Salesforce’s Price to Sales ratio, for example, when one company makes their money off of interest payments and the other company makes their money off of enterprise technology services? These ratios only tell part of the story and must be used in conjunction with other metrics to truly evaluate a given stock.
- Overly Simplifies Complex Information: While making these ratios so simple can be advantageous in that it gives investors a quick snapshot into a company’s value, the oversimplification has serious drawbacks as well. By simplifying complex information into just a single ratio, other factors that can influence a company’s performance are effectively ignored and disregarded.
- Only Accounts for Past Data: While the Forward P/E ratio is based off of future projections, they are not always reliable or trustworthy. For the most part, these market multiple ratios only consider a company’s finances from the past and at a certain point in time, and neglect to include a company’s growth prospects or future business operations.
- Not Adjusted for Different Accounting Practices: Ratios such as the P/B ratio are not good when comparing companies with different accounting practices- namely international companies. Even if a company like Salesforce and SAP have similar business operations, they may have vastly different accounting policies. After all, one company is American, and the other is German. The multiples may be easily misinterpreted as a result, with inconclusive comparisons.