What does the PEG ratio stand for? Why is it used and how could we define it? This article focuses on answering these specific questions. The PEG ratio stands for price earnings to growth, being regarded as an investment calculation that assesses the value of a stock, considering the current earnings and the potential anticipated growth of the company.
To that end, investors utilize this ratio in order to calculate if a stock is overpriced or underpriced, by factoring in the current earnings in link with the rate of growth of a company.
Analyzing the Specifications of the PEG Ratio
The PEG ratio could be conveyed as an enhanced P/E ratio (price to earnings ratio). That’s because it also evaluates the growth of the company by dividing the P/E by the rate of annual growth. However, considering that P/E doesn’t investigate the place in which the firm is likely to be in the foreseeable future, a stock might seem like an appealing investment. Nonetheless, in truth, the firm’s growth pattern might not be the best, as it could be stagnant.
By factoring this in, the stock might be conveyed as a bad investment. Nevertheless, that isn’t to say that PE is a useless ratio, since it has its use, as well. In fact, investors turn to both these ratios for different reasons. This outlines one thing: it’s quintessential not to depend on a singular calculation when it comes to investing. That’s because each specific metric has a designated purpose, aiming at providing a wider perspective over an investment.
What About the Formula of the PEG Ratio?
So, how do you calculate the PEG ratio? The formula is quite simple;
As long as you understand the way in the calculations required by the formula, it is quite easy to solve. More specifically, you calculate the numerator by dividing the market price per share by the earnings per share. On the other hand, though, the denominator is a bit more complicated. Investors can calculate the EPS growth by utilizing the historic growth rate or, alternatively, the unexpected future growth rate.
What Is the PEG Ratio Utilized For?
As we’ve said beforehand, this ratio aims at assessing whether a stock is undervalued or overvalued. It’s a value calculation that actually determines the worth of a company, irrespective of the worth of the stock. In essence, an utterly worthless company would have high stock prices – primarily because investors usually keep pushing the prices up. One example worth noting is that of Enron in the mid-1990s.
On a final note, considering that a firm’s earnings and growth potential depend on the individual characteristics of the industry, there aren’t any specific numbers that would pinpoint whether a stock would be a sensible investment or not. As a rule of thumb, though, a PEG ratio less than 1 is thought to be a good buy, primarily because the stock price is undervalued.