What is PEG Ratio Formula?
The term “PEG ratio” or Price/Earnings to Growth ratio refers to the stock valuation method based on the growth potential of the company’s earnings. The formula for PEG ratio is derived by dividing the stock’s price-to-earnings (P/E) ratio by the growth rate of its earnings for a specified time period.
PEG Ratio Formula can be expressed as below,
P/E ratio = Stock Price / Earnings per share
There are two methods of calculating the PEG ratio and they are:
- Forward PEG
- Trailing PEG
Forward PEG: In this method, the earnings growth rate is determined on the basis of annualized future growth rate for a certain period of time, usually a period of up to five years.
Trailing PEG: In this method, the earnings growth rate is determined on the basis of the stock’s trailing growth rates. The sources of such growth rate could be from the previous 12 months, last fiscal year or some sort of multiple-year historical average.
The PEG ratio formula calculation is simply done by using the following four steps:
Step 1: Firstly, determine the current price of the company stock from the stock market.
Step 2: Next, determine the net income of the company from the income statement. Then, figure out the portion of the profit going to the shareholders after deduction of preference dividends. Now, divide the portion of the net income by the outstanding no. of shares to arrive at the earnings per share or EPS.
EPS = (Net income – Preference dividends) / No. of outstanding equity shares
Step 3: Next, divide the current stock price of the company by its earnings per share to calculate the P/E ratio.
Step 4: Next, determine the future earnings growth rate based on the financial projection of the company as per forwarding PEG ratio method. The financial projection is prepared on the basis of the company-specific plans and future growth potential of the industry and market overall. On the other hand, the PEG ratio can be derived by using the past performance of the company as per the Trailing PEG ratio.
Step 5: Finally, the formula for PEG ratio calculation is derived by dividing the P/E ratio by the growth rate of its earnings for a specified time period as shown below.
PEG ratio = P/E ratio / Earnings growth rate
Example of PEG Ratio Formula (with Excel Template)
Let’s see some simple example of PEG Ratio Formula to understand it better.
Let us take the example of company ABZ Ltd which is in the business of manufacturing mobile phones. The company has witnessed a tremendous change in the market potential with the launch of its new product and as such the future growth is expected to be higher than the past. The stock of the company is currently trading at $65 per share.
Below is given data for calculation of forward PEG ratio and a trailing PEG ratio of company ABZ Ltd
Therefore, the calculation of P/E ratio will be as follows
P/E ratio = Current price / EPS for FY18 = $65 / $3.61
P/E Ratio= 18.00
Trailing Earnings Growth Rate
Therefore, the Earnings growth rate for trailing five years can be calculated as,
The earnings growth rate for trailing five years = (EPS for FY18 / EPS for FY14)1/4 – 1
= ($3.610 / $3.000)1/4 – 1
Trailing Earnings Growth Rate = 4.74%
Trailing PEG Ratio
Therefore, the calculation of Trailing PEG ratio will be as follows,
Trailing PEG ratio = 18.00 / 4.74
Trailing PEG Ratio= 3.80
Forward Earnings Growth Rate
Therefore, the calculation of Earnings growth rate for the future five years will be as follows
The Earnings growth rate for future five years = (EPS for FY23P / EPS for FY18)1/5 – 1
=($6.078 / $3.610)1/5 – 1
Forward Earnings Growth Rate = 10.98%
Forward PEG Ratio
Therefore, the calculation of Forward PEG ratio will be as follows,
Therefore, Forward PEG ratio = 18.00 / 10.98
Forward PEG Ratio= 1.64
Therefore, it can be seen that the PEG ratio is expected to improve in the coming years which is a good indication for the company.
Relevance and Use
It is very important to understand the concept of PEG ratio because an investor uses this ratio to analyse the earning potential of a stock. A stock with low P/E ratio may seem like a good buy, but then taking the company’s growth rate into account to derive the PEG ratio of the stock, the story might change a lot. Additionally, a lower PEG ratio indicates that the stock may be undervalued given its earnings performance. The degree of variation (a spread of over or under-priced stock) of PEG ratio varies across the industry and across company type.
However, there is a broad rule of thumb that it is desirable to have a PEG ratio of less than one. Further, the accuracy of the PEG ratio is as good as the inputs used and so one should be careful in using the input data. For instance, the use of historical growth rates may end up providing inaccurate PEG ratio if the future growth potential is likely to deviate from historical growth rates. Consequently, calculation methods using future growth and historical growth are distinguished by the terms “forward PEG” and “trailing PEG” respectively.
This has been a guide to PEG Ratio Formula. Here we discuss how to calculate PEG Ratio along with the practical examples and downloadable excel sheet. You can learn more about accounting from the following articles –