The PEG ratio or Price/Earnings to Growth ratio is one of the most popular valuation ratio calculated for determining the relative trade-off between the price of a stock, the earnings per share (EPS), and the company's expected growth rate. This was popularized by Peter Lynch, who wrote "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have its PEG equal to 1.
Basic formula:
PEG = (P/E) / (projected growth in earnings).
For example, a stock with a P/E of 30 and projected earnings growth next year of 15% would have a PEG of 30 / 15 = 2. A lower ratio is 'better' (cheaper) and a higher ratio is 'worse' (expensive).
What does PEG tell us?
PEG, which is derived from P/E ratio, is generally higher for a company with a higher growth rate. Using just the P/E ratio would make high-growth companies overvalued relative to others. PEG is a popular indicator of a stock's correct value. Similar to PE ratios, a lower PEG means that the stock is undervalued more.
It is preferred than P/E ratio because it also accounts for growth. If a company is growing at 30% a year, then the stock's P/E could be 30 to have a PEG of 1. The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth.
Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.
On the flip-side, the PEG ratio is less reliable for measuring companies with low growth rates. Large, well-established companies for instance may offer dependable dividend income but little opportunity for growth.A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to number of factors like market conditions, expansion setbacks and hype of investors.
To conclude, we can say that though there are certain advantages of using the PEG ratio like, it accounts for growth and easy to calculate. But,it has certain disadvantages, like it can be an misleading indicator at times. Thus it should be used with utmost care and only in those situations, along with other parameters, where it shows the right picture. Well, Investing is not that easy ! Right ?