August 23, 2014

PEG Ratio Explained

The PEG Ratio for analysing the value of stocks is insightful because it combines the forecast earnings for a stock as well as price and earnings. The formula for calculating the PEG ratio of a stock is simply; PE Ratio / Forecast Earnings Growth = PEG.

One of the key benefits of the PEG ratio is that it provides a basis for comparison for all companies, and not just those in the same or similar sectors. So in essence, the PE ratio is useful for telling you whether a stock is ‘cheap’ but the PEG ratio provides further insight as to whether a stock is truly undervalued.

So how does the PEG ratio work? It is underpinned by the Growth at Reasonable Rate (GARP) theory, which assumes that a value of one represents a fair valuation of a stock. Any figure above one suggests an overvalued stock, and any PEG ratio of below one suggests that a stock is particularly undervalued. For example a company that possesses a PE ratio of 12 and a forecast growth of 12%, would be deemed as a fairly valued company as it is equal to one.

However, as with all stock valuation methods, the PEG ratio can’t tell the whole picture. One must remember that its results are based on forecasts, and these forecasts are by no means guarantees of future earnings. Also, the PEG ratio may not take into account some key draws of a particular company such as that regularly pays good dividends.