PEG or price/earnings to growth ratio is simply calculated by taking P/E ratio and dividing it by earnings growth rate. Price to earnings is the most important component of PEG calculation.
Price to earning ratio is calculated by taking current market price of the stock and dividing it by the earnings per share or EPS. Normal Price to earnings ratio is not considering future increase in earnings.
Earnings per share or EPS is calculated by taking net profit for common stockholders and dividing it by number of equity shares outstanding.
This means to calculate Price/Earnings to Growth ratio, you are required to have following things;
- Net profit available for common stockholders
- Weighted average number of shareholders
- Market price of the stock
- Earnings growth rate
After collecting above details, you are required to find the P/E and divide it by the projected earnings growth rate to find out Price/Earnings to Growth ratio.
PEG = Price to earnings / projected earnings growth rate.
Company’s P/E = 30
Projected profits of the company is to be increased at a rate of 15% over the next 10 years.
PEG = Price to earnings ratio / projected earnings growth rate = 30/15 = 2
Price/Earnings to Growth ratio will help you to know whether market has undervalued or overvalued a stock in comparison to another company’s stock. If the PEG is higher, the market has overvalued the stock. If the PEG is lower, the market is undervalued the stock.
A stock might be trading at a high P/E multiples in market indicating its overvalued, but if it maintains a high growth rate then the PEG will be low, indicating its still a good buy. If the same stock is considered by analyst to grow at a very low rate than your estimated rate, then your PEG will be wrong in comparison to analyst’s price earnings to growth ratio.
To compute PEG, you need to first decide which estimate to be considered in the formula. If you are expecting the company to maintain the same profit as it made in the past then take the same rate to your calculation or else consider the market expected rate.
Similarly, if the company will have a low profit it future than the earlier estimates, then the PEG is to be high, indicating the stock is overpriced.
As a rule of thumb;
- If the PEG is equal to 1, it indicates that the stock is fairly priced.
- If Price/Earnings to Growth ratio is less than 1, market has undervalued the stock or analysts have set their estimates too low than your estimates.
- If price earning to growth ratio is greater than 1, this tells that the market is expecting increase in earnings than the earlier estimates or the stock is overvalued.
The main factor in the calculation of PEG is the earnings growth rate. If you make mistakes in projecting the earnings, then Price/Earnings to Growth ratio will be wrong.
We suggest you not to consider only one parameter for your investment decisions. You need to analyse each items of the financial statements to understand the stock better before investing.