How To: PEG Ratio

PEG Ratio or Price to Earnings Growth Ratio is a ratio that attempts to adjust for anticipated growth in company earnings in comparison to PE Ratio.

It is calculated by taking (Price/EPS)/EPS growth or PE Ratio/EPS growth.

The question you should be asking is that where does this projected growth come from? Growth expectations are usually based on 5-year estimates of growth that analysts covering the stock project. The projections are never perfect, but they give you a baseline of what Wall Street is expecting from the company. When companies beat on earnings estimates they generally go up (but not always!). Wehn at company beats on earnings but the stock goes down, it is usually indication of the company forecasting for slower growth in the future or that the business is not as strong elsewhere because earnings is certainly not a catch all metric for business success.

Seemingly parodically, earnings growth may not always add value to the business. If a business is growing earnings, but its return on investment is not increasing at a rate above the companies cost of capital, the company could be creating negative value for shareholders. This could make earnings growth a bad thing and illustrates how using ratios is an incomplete analysis of a business.

PEG ratio shares same downsides of PE Ratio of manipulated earnings and lack of taking capital efficiency (how much capital it takes to produce earnings) into account. It is best to use PEG ratio when comparing businesses in similar industries and where earning can be trusted to be a more reliable metric.