What is Price/Earnings-to-Growth Ratio (PEG)?
The PEG ratio is a derivative of the P/E ratio that takes into account future growth in earnings.
How to calculate a PEG Ratio
The formula for the PEG ratio is:
PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings Per Share Growth
The PEG ratio uses the basic format of the P/E ratio for a numerator and then divides by the potential growth for the stock. The two ratios may seem to be very similar but you can see the obvious difference with a calculation.
Let us take Company XYZ stock. Say XYZ is currently trading with a P/E ratio of 30. Typically, this would be considered an "expensive" stock. But let's also assume analysts forecast growth in earnings per share of +40% for the next year.
In this case, XYZ's PEG ratio would be:
PEG Ratio = 30 (P/E ratio) / +40% (earnings growth) = 0.75
A rule of thumb is that any PEG ratio below 1.0 is considered to be a good value. So even though XYZ is highly valued based on the P/E ratio, the PEG ratio says that it is undervalued relative to its growth potential.
For more explanation of how to use the PEG ratio in conjunction with other valuation ratios, please read our educational article Don't Be Misled By the P/E Ratio.
Why do PEG Ratios matter?
The PEG ratio acts as a measure of value that takes into account future growth. Using this metric, investors can gauge whether high-growth stocks may be undervalued, even if they don't appear so with the more common P/E ratio.
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