What is PEG Ratio?
Price Earnings growth (PEG) ratio is the ratio between price to earnings to the expected growth rate of a company and it helps in describing the earnings and valuations of the company.
Brief Explanation
The PEG ratio, which is also commonly known as Price Earnings to growth ratio, is originally a ratio lies within a ratio. First of all, you are required to figure out what is PE ratio for the stock. Once you have this number and information, you’re convenient to compute the overall ratio of P / E to “G.” “G,” which is stands for annual growth of earnings per share. The PEG ratio collates a current share price of a company with its current earnings per share, and after that, it evaluates that PE ratio against the rate at which the firm’s earnings are extending.
- The price-earnings to growth ratio provide you a more refined look at a prospective value of investment since an irresistibly high P / E ratio does not inevitably hold up under scrutiny once you take the growth rate of the company into account.
- The price-earnings to growth ratio can provide you a picture that how costly or cheap a stock of the company is in relation to the rate at which its earnings are presently rising and the rate at which they are anticipated to hike over the long-term.
- This recommends big merit over computing a Price Earning (P / E) ratio of a firm individually since that amount only considers the value of the company in terms of the earnings, which is presently generating.
- A lower-Price Earning Growth ratio usually specifies that business is presently undervalued based on the performance of its earnings, whereas a higher Price Earning Growth ratio generally specifies that business is presently overvalued. It means it states that the to be fairly valued or price PEG ratio required to be equal to
- It means it states that to be fairly valued or price Price Earning Growth ratio required to be equal to the growth rate of earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more or should be one.
Infosys was trading at a very High PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more in 1997-2000; however, most analysts during that time recommended a BUY for this stock? Why? They were looking at some other valuation parameter in conjunction with PE Ratio, i.e., Price Earning Growth Ratio. PEG ratio is used to determine stock’s value while taking into account earnings growth. Infosys was growing exponentially during that time period, and hence, the PEG ratio provided valuable clues to the analyst about its fair valuation.
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For eg:
Source: PEG Ratio (wallstreetmojo.com)
PEG Ratio Formula
Formula to calculate the PEG Ratio = Price to earnings (P/E) ratio / Growth rate. Or
Price-Earnings ratio (P/E) ratio / Earnings per share growth rate.
Importance of Price Earnings Growth
The ratio is generally used to provide an estimate of the fair value of the stock and is provided by different sources of financial and stock data. My source of PEG Ratio is Ycharts.
Some of the PE ratio significance are discussed below:
- Price Earning Growth is based on the assumption that a PE ratio is positively linearly correlated to the
expected growth rate in earnings, i.e., PEG is constant - At higher rates of growth, PEG ratios are stable and less sensitive to changes in growth than
PE ratiosPE RatiosThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more, which makes Price Earning Growth ratios more suitable for valuing high-growth companies - PEG ratio is used to value growth companies where it is assumed that growth opportunities arise from reinvesting at a premium rate of return or from efficiency gains. An example here could be the US Technology space. Here is an example of the US Technology Sector, Companies with Market Capitalization of more than $10bn
source: ycharts
- Price Earning Growth ratio is Less appropriate for measuring companies without high growth. Large, well-established Utilities or Infrastructure companies may offer dependable dividend income, but little opportunity for growth. Here is an example of the Utilities Sector, Companies with Market Capitalization of more than $10bn. Please note that though we have calculated the Price Earning Growth ratio here, it is not advisable for mature companies/sectors.
source: ycharts
Interpretation
“If Price Earnings ratio of any company which is fairly valued will be equal to growth rate.” The following are the interpretation of the Price Earnings Growth ratio.
- If the PEG ratio is equal to 1, it will be stated that fairly priced or valuation of the business.
- If the Price Earning Growth ratio is less than 1, it will be stated that undervaluation of the business.
- If the PEG ratio is more than 1, it will be stated that overvaluation of the business.
PEG Ratio Examples, Calculation, and Analysis
The following are some of the examples of Price Earning Growth ratio mentioned below for proper understandings:
Example # 1
Equity shares of the Andy Company are being traded in the market at $ 54 per share with earnings per share of $ 6. The dividend payout of the company is 72 %. It has 1 00,000 equity shares of $ 10 each and no preference shares. The book value of shares is $ 42. The growth rate of earning per share is 10 %. You are required to calculate the price-earnings to growth (PEG) ratio of Andy Company and analyzed its impact.
The solution to Price Earning Growth Ratio Example # 1.
The following are the necessary calculation and workings mentioned below.
Calculation of Price Earning Growth ratio.
- Given that, the Market price per share =$ 54 and the Earnings per share (EPS) = $ 6
- So, Price Earnings (P/E) ratio = Market price per share / Earnings per share = $ 54 / $ 6 = 9
- So, PEG ratio = P / E ratio / Growth rate of earnings per share = 9 / 10 = 0.9
- Therefore, the Price Earning Growth ratio of Andy Company is 0.9, and as the PEG ratio is less than its growth rate or one, it will be stated as undervalued.
Example # 2
A company has an earning per share of $ 8, and the market value of a share is $ 64 per share. What will be the price-earnings ratio of the company? Calculate the PEG ratio of the company and states its impact if
- Growth rate of earnings per share will be 10 %
- Growth rate of earnings per share will be 8 %
- Growth rate of earnings per share will be 6 %
The solution to PEG Ratio Example # 2
The following are the necessary calculation and workings mentioned below.
Calculation of Price-earnings ratio
- Given that, Market price per share = $64 and Earnings per share = $8,
- So, PE ratio = Market price per share / Earnings per share
- PE Ratio = $ 64 / $ 8 = 8.0x
Calculation of Price Earning Growth ratio in case of the growth rate of earnings is 10 %
- Price Earning Growth ratio = P / E ratio / Growth rate of earnings = 8 / 10 = 0.8
- As the Price Earning Growth ratio is less than one, it is stated as undervalued.
Calculation of Price Earning Growth ratio in case of a growth rate of earnings is 8 %
- Price Earning Growth ratio = P / E ratio / Growth rate of earnings = 8 / 8 = 1
- As the PEG ratio is equal to one, it is stated as fairly priced.
Calculation of Price Earning Growth ratio in case of the growth rate of earnings is 6 %
- PEG ratio = P / E ratio / Growth rate of earnings = 8 / 6 = 1.33
- As the Price Earning Growth ratio is more than one, it is stated as overvalued.
Example # 3
A company ABC Limited is capitalized as follows: (Amount in $)
The following are the information is relevant as to its financial year just ended: (Amount in $)
| Particulars | Amount |
|---|---|
| Profit after taxation at 50 % | 54,200 |
| Capital commitments | 24,000 |
| Market price of ordinary shares | $ 4 per shares |
| Ordinary dividends paid | 20 % |
| Depreciation | 12,000 |
| Growth rate of earnings per share | 11 % |
You are required to state the following showing the necessary workings:
- Price-earnings (P / E) ratio
- Price-earnings to growth ratio (PEG) ratio and its impact
The solution to Price Earning Growth Ratio Example # 3
The following are the necessary calculation and workings mentioned below.
Calculation of Earnings per share (EPS)
- Before calculating the Earning per share we need to calculate the Profit after tax available to Ordinary or equity shareholders
- So, Profit after tax available to ordinary shareholders
- = Profit after tax – Preference dividends = 54,200 – (7 % of 60,000) = 54,200 – (7 * 600) = 54,200 – 4,200 = 50,000
- So, Earnings per share = Profit after tax available to ordinary shareholders / Number of ordinary shares = 50,000 / 1, 60,000 = 5 / 16 = 0.3125. Therefore the EPS is 0.3125
Calculation of PE ratio
- Given, Market price of ordinary share = 4 per share
- Earnings per share (Calculated above) = 0.3125
- Price earnings ratio = Market price of ordinary shares / Earnings per share = 4 / 0.3125 = 40,000 / 3125 = 12.8. Therefore the Price earnings ratio is 12.8
Calculation of Price earnings to growth (PEG) ratio
- Given, Price earnings ratio [As calculated above in point no. (ii)] = 12.8
- Growth rate of earnings per share = 11 %
- So, Price Earning Growth ratio = Price earnings ratio / Growth rate of earnings per share = 12.8 / 11 = 1.164 (Approx)
- Therefore the PEG ratio is 1.164, and as the Price Earning Growth ratio is more than one, it will be stated as overvalued.
Example # 4
A company Mark Limited has the following relevant information for the financial year ended as on 31st March 2015. (Amount in $)
You are required to calculate the following showing the necessary workings:
- Price-earnings ratio.
- PEG ratio and its impact.
- Analyze the require a growth rate of earnings per share to make the PEG ratio fairly priced.
The solution to PEG Ratio Example # 4
The following are the necessary calculation and workings of mentioned below.
Calculation of profit after tax. ( Amount in $ )
| Particulars | Amount |
|---|---|
| Operating Profit (a) | 2,50,000 |
| Less: Interest on Loans (b) | |
| I. Interest on secured loans @ 15 % = 2,50,000 * 15 / 100 = 37,500 | |
| II. Interest on unsecured loans @ 12.5 % = 1,00,000 * 12.5 / 100 = 12,500 | |
| Total Interest (I + II ) | 50,000 |
| Profit before taxProfit Before TaxProfit before tax (PBT) is a line item in a company's income statement that measures profits earned after accounting for operating expenses like COGS, SG&A, depreciation & amortization, and non-operating expenses. It gives the overall profitability and performance of the company before making payments in corporate taxes.read more (PBT) = ( a – b ) | 2,00,000 |
| Less income tax @ 50 % = 2,00,000 * 50 / 100 | 1,00,000 |
| Profit after tax (PAT) = PBT – Income tax | 1,00,000 |
Calculation of Earnings per share
- Given, Number of equity shares = Total Equity share capital / Rate per share = 5, 00,000 / 20 = 25,000
- Profit after tax (As calculated above in point no. i) = 1, 00,000
- So, Earnings per share (EPS) = Profit after tax / Number of equity shares = 1, 00, 000 / 25,000 = 4
- Therefore the Earnings per share of Mark limited is $ 4 per share.
Calculation of Price-earnings ratio
- Given that, Earning per share (as calculated above) = $ 4
- And the Market price per share = $ 50
- As we know, Price-earnings (P / E) ratio = Market price per share / Earnings per share. So, Price-earnings ratio = $ 50 / $ 4 = 12.50
- Therefore, the price-earnings ratio of Mark limited is 12.50
Calculation of Price Earning Growth ratio
- Given that, the Price-earnings ratio (as calculated above) = 12.50
- And the Growth rate of earnings per share = 8 %
- So, Price Earning Growth ratio = Price earning ratio / Growth rate of earnings per share = 12.5 / 8 = 1.5625 = 1.56 (App.)
- Therefore, the Price Earning Growth ratio of Mark limited is 1.56, and as the PEG ratio is more than one, it will be stated as overvalued.
Calculation of Growth rate of earnings per share for a fairly priced Price Earning Growth ratio.
- Given that, Price earning ratio (as calculated above in point no. iii) = 12.50
- As it is already stated that the PEG ratio should be fairly priced, so the PEG ratio should be taken as 1.
- We know that the PEG ratio = Price earning ratio / Growth rate of earnings per share.
- So, PEG ratio = 12.50 / Growth rate of earnings per share = Growth rate of earnings per share = 12.50 /Price Earning Growth ratio = Growth rate of earnings per share = 12.50 / 1 = 12.50
- Therefore, to need a fairly priced Price Earning Growth ratio, the growth rate of earnings per share will be 12.50 %
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