What Is The PEG Ratio Formula?
PEG Ratio Formula refers to the mathematical expression or equation that allows one to calculate the stock value based on the growth potential of the company’s earnings. The formula for the 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 stands for Price/Earnings to Growth ratio, which lets analysts assess how likely a firm is to grow in the coming times. The ratio obtained can either be positive, negative, or null, depending on which the calculations are interpreted.
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PEG Ratio Formula Explained
The PEG ratio formula is the expression using which the price/earnings of the firms are studied with respect to the growth in their earnings. Additionally, it helps analysts examine the interrelation between the company’s growth rate, stock price, and earnings per share (EPS).
One of the most widely used metrics that help businesses identify their ability to grow and expand is the Price-to-Earnings (PE) ratio. However, merely calculating this ratio does not provide an accurate figure to reveal the capability of a firm to grow. Instead, it misleads analysts or companies by overvaluing firms in comparison to others.
Using the PEG ratio formula, on the contrary, gives more relevant figures as it checks the price or earnings against the company’s growth rate. As a result, the value obtained is more reliable.
PEG Ratio Formula can be expressed as below,
P/E ratio = Stock Price / Earnings per share
The ratio can either be positive negative or null. A positive PEG ratio reveals the ability of a business to grow in a positive direction. This means the firm’s EPS has shown positive growth and will continue to grow better than that recorded the previous year
On the contrary, a negative ratio value indicates that despite the EPS for both current and previous years being negative, the growth rate of a business’s EPS will still be positive.
Null PEG, however, clearly indicated a negative growth rate of EPS.
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 based on the annualized future growth rate for a certain period, usually up to five years.
Let us take the example of ABZ Ltd, which manufactures mobile phones. The company has witnessed a tremendous change in the market potential with the launch of its new product, and as such, future growth is expected to be higher than in the past. The stock of the company is currently trading at $65 per share.
Below is given data for calculation of forwarding PEG ratio and a trailing PEG ratio of company ABZ Ltd
Therefore, the calculation of the 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 the 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 the 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 the 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
The PEG ratio formula helps obtain the percentage that helps companies learn about their capability to grow over time. The importance of this ratio, however, are many. Listed below are the points that unveil the relevance and application of these ratios. Let us have a look at them:
- An investor uses this ratio to analyze the earning potential of a stock.
- The degree of variation (a spread of over or under-priced stock) of the PEG ratio varies across the industry and company type.
- A stock with a 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.
- A lower PEG ratio indicates that the stock may be undervalued, given its earnings performance.
However, a broad rule of thumb is 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, so one should be careful in using the input data. For instance, historical growth rates may provide an 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 “forward PEG” and “trailing PEG,” respectively.
This article has been a guide to what is PEG Ratio Formula. Here, we explain the concept along with how to calculate it, an example, methods, relevance & use. You can learn more about accounting from the following articles –
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