What is the PEG Ratio built of?
PEG Ratio Formula
Message From Author
Let's PEG! No, not that kinda kind of PEG. I mean Price/Earnings-to-Growth ratio, PEG.
Have you ever been to a site scanner like www.finviz.com to filter for stocks and noticed there’s an option called PEG? Well, I am here to explain it because it is a very useful ratio to understand. This financial metric can help investors better acknowledge stocks they're considering investing in. Either one, when you come across a company and want to determine its value standings. Or, two when you are searching for a particular company using a screener and need to narrow down your list closer to your core criteria.
What is PEG Ratio
PEG stands for Price/Earnings-to-Growth. You can use the PEG ratio to your advantage to seek out “growth” at a reasonable price. It’s a great ratio to finding value in the market.
In order to fully understand why it’s useful and how it works you first need to look deeper into what it's made of. To do so you need to know how the P/E ratio works. So, let us take a look at that first, or let me refresh your memory if you’re already familiar with it. What is P/E Ratio
The P/E ratio stands for Price-to-Earnings ratio. This stat can help you compare the price of a company’s stock to the earnings the company produces. This comparison helps you understand whether an equity is overvalued or undervalued in the eyes of the market. The P/E ratio can also guide you by comparing the valuation of the individual stock to the over all industry it is in. Thus, helping you see if the stock is generally priced too high or too low.
The P/E ratio is derived by dividing the price of a stock by the stock’s earnings. Let’s look at the actual formula:
P/E = Price per Share / Earnings Per Share
The market price of a stock tells you how much people are willing to pay to own the shares, while the P/E ratio tells you how much people are willing to pay over the earnings. You can think of it as the “multiple”. Let’s jut say ticker XYZ is at $100 per share and the company produces $5 per share in annual earnings. In this example, the P/E ratio of the company’s stock would be 20 ($100 per share / $5 in earnings per share = P/E 20). In perspective, given the company’s current earnings, it would then take 20 years of added earnings to equal the cost of the investment. You are paying $100 to get back $5 per year. ($5 in earnings per share x 20 years = $100).
The ratio would be exactly the same if we view it as a whole rather than in a “per share” basis. So, if a company has a market cap of $100,0000,000. But, every year it earns $5,000,000 the math is the same. ($100,000,000 / $5,000,000 = 20). The P/E ratio is still 20. Now you know, if the P/E ratio is very high people are willing to overpay for earnings the company brings which may mean it is overvalued due to high optimism. On the other end, if it's too low, people might not be willing to pay too high for its earnings and are being pessimistic. Contradicting itself. If the P/E ratio is low it might indicate it is undervalued and being over looked. While, a P/E too high might indicate everyone is hyping it up, but, perhaps for a good reason. That’s where your own due diligence and research comes into play. To figure out if its current ratio is justifiable.
We can now evolve to the next ratio. But before, let me refresh your memory over what the PEG ratio means. As mentioned above, “PEG stands for Price/Earnings-to-Growth. You can use the PEG ratio to your advantage to seek out “growth” at a reasonable price. In different terms, the PEG ratio illustrates the relationship between stock price, earning per share, and the company's growth rate. As you can see it is very similar to P/E Ratio, only this time you taking into account its growth.
The PEG ratio consists of the PE ratio divided by the company's growth rate. Let’s look at the actual formula:
PEG = PE Ratio / Growth rate of earnings
Let’s use the example we used above again, but this time to calculate the PEG ratio. If company XYZ is at $100 per share and the company produces $5 per share in earnings. The P/E ratio of the company’s stock would be 20. Now, let’ add in the fact that those earning grow at a rate of 15% per year. We then do the math as followed:
PE Ratio 20 / 15 = 1.33 PEG = 1.33
Generally speaking, a company with a PEG ratio below 1 is considered undervalued. A company with a PEG ratio around 1 is considered fairly valued. A company with a PEG ratio greater than 1 is considered overvalued.
When it come to the PEG Ratio, there are 3 possible scenarios:
Positive PEG: There is a positive EPS as well as positive growth in EPS compared to a year ago.
Negative PEG: EPS has a positive growth rate due to the nature of the calculation even though both EPS values are negative.
Null PEG: EPS has a negative growth rate, so no PEG Ratio will show up.
You now have the ability to compare two or more companies using the PEG ratio to see which one is giving you a better value for your buck. If you are starring at two similar companies the PEG will guide you to the better one, as followed: If Company A has a P/E of 15 while growing earnings at a rate of 10%, that is a PEG Ratio of 1.5. If company B also has a P/E Ratio of 15 but is growing earnings at a rate of 12%, the PEG ratio is 1.25. Company B is clearly at a better value.
Another example: If Company A has a P/E Ratio of 12 while earnings grow at a rate 15%, its PEG ratio would be 0.8. If company B has a P/E Ratio of 14, but earnings are growing at a rate of 25%, the PEG Ratio is equal to 0.56. The better value for your buck is company B. Notice how Company A had a lower P/E but, the earnings growth rate of Company B, is compromising companies A’s over all value.
Using Scanner/ Filter
This part might be a little tougher, and for the more experienced but, you should now have the ability to filter through stocks and narrow down your list based on a a specific criteria you are searching for. I use this often when I already have a set up in mind based on a “range.” I set myself 2 scenarios of what I am trying to seek for, one on the lower end and the other on the higher end and then its helps give me a range to input on my scanner in the PEG Filter. For example, I am looking for a company thats is around a P/E Ratio of say “10”, and I particularly want it to be growing roughly 20% to 30% per year in earnings. I can now do: 10/20 = 0.50, and 10/30 = 0.33. I can add a custom input to filter stocks between a PEG Ratio of 0.30 to 0.55. I can also use the PEG ratio given to me by a stock I'm looking into, to find companies with similar performance to compare.
Message from Author
If you enjoyed this letter please share it so that we can get it to the hands of other investors. My goal is to help as many people as possible on their journey to investing in the stock market. By sharing, you are also helping and supporting me which then motivates me to write more letters! I highly appreciate it! Thank you!
Carlos Valadez (Charlie)