PEG Ratio - Price/Earnings to Growth Ratio

The PEG or price-earnings to growth ratio is a valuation ratio used along with the P/E ratio, in stock analysis. It calculates the price of a stock in relation to the earnings per share, and the projected growth of the company. The PEG ratio is calculated as:

PEG ratio = Price to Earnings ratio/ Annual EPS growth
Note: The expected growth rate could be for the next 1 year or 5 years.

Understanding the PEG Ratio

An investor can use the PEG ratio to determine if a stock is overvalued or underpriced. One can use the PEG ratio as follows:
PEG ratio > 1 implies that the stock is overvalued. It simply means that the company.s future earnings is not going to grow much and the stock may undergo a correction in price.
PEG ratio = 1 implies that the stock is fairly valued given the expected growth rate.
PEG ratio < 1 means the stock is undervalued as the markets are currently underestimating growth.
Negative PEG ratio: This could be the case where the current earnings are negative, or the future earnings are going to decline.
An Example: Say 2 companies A and B have a P/E ratio of say 40 and 10, with earnings growth being projected at 45% and 2% respectively. We arrive at a PEG ratio of 0.88 for company A and 5 for company B. We see that even though company A has a high PE ratio of 40, considering the PEG ratio it is undervalued as it has huge growth potential.

PEG Ratio for Tech Stocks

 Company P/E Ratio (2014 estimates) Forecast 12 Month Forward PEG Ratio Amazon 266.36 8.3 Google 24.67 1.39 Akamai 24.61 2.11
Source:Nasdaq
What we see here is that Amazon is overpriced not only when we take into account the P/E ratio, but also the PEG ratio. We have always stated that Amazon is overpriced which is reflected in our analysis of the stock.

Things to remember while using the PEG ratio

• The PEG ratio relies on projections or future earnings which may not always be correct.
• The PEG ratio gives accurate results for growth companies. It gives inaccurate results for stocks which pay high dividend.

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