PEG ratio
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The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share, and the company's expected future growth.
A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that gets close to 2 or higher is generally believed to be expensive, that is, the price paid appears to be too high relative to the estimated future growth in earnings.
It is a generally accepted rule of thumb that a PEG ratio of 1 represents a reasonable trade-off between cost (as expressed by the P/E ratio) and growth: the stock is relatively cheap for the expected growth. If, for example, a company is growing at 30% a year, then the stock's P/E could be as high as approximately 30. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values.
The PEG ratio is commonly used and provided by various sources of financial and stock information. Despite its wide use, the PEG ratio is only a rule of thumb, and has no accepted underlying mathematical basis; in particular, the PEG ratio's validity at extremes (for example, for use with low-growth companies) is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market).
When the PEG is quoted in public sources, it may not be clear whether the earnings used in calculating the PEG is the past year's EPS or the expected future year's EPS; it is considered preferable to use the expected future growth rate.
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[edit] Advantages
Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.
[edit] Disadvantages
The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.
A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, and hype of investors.
The convention that (PEG=1) is appropriate is somewhat arbitrary and considered a rule of thumb metric. Mathematically, growth faster than growth of the economy cannot be infinite (or the company would be larger than the economy), and the PEG ratio does not correct for the period of time that faster-than-normal growth will continue. Hence, the PEG ratio lacks a coherent conceptual framework, and is used solely as an indication of the extent of the growth/price trade-off.
At extremes, and particularly for low-growth companies, the PEG ratio implies valuations that may appear to be nonsensical. For example, the PEG ratio "rule of thumb" implies that a company with 1% growth in earnings per annum should have a P/E ratio between 1 and 2, a level that would appear to be extremely low.
Here is an example of a stock bought and held until the growth has normalized[1]. It assumes the long-term P/E = 15. This is historical fact as shown in this |graph.
Company's growth projection = 30% Number of years out growth is expected to continue = 3 years Historical PE of company = 15 Current earnings of the company = $10/share
Solve for investment return: Stock price now so that PEG=1 ((P/10)/30=1) = $300/share Projected earnings after 3 years (PV=10,n=3,30%) = $22/share Stock price after 3 years (P/E=15=P/22) = $330/share Your personal investment return (PV=300,n=3,FV=330) = 3.2%
