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What Is A PEG Ratio?

PEG ratio logoMany investors are familiar with the use of the Price-to-Earnings (P/E) ratio as a valuation metric highlighted in the article – “How to Value a company” by my Foolish colleague, Sudhan.

While the P/E ratio is commonly used, a stock’s price/earnings to growth (PEG) ratio may give a more complete story by taking into account the expected future growth rate.

How to Use the PEG Ratio

The PEG ratio is considered to be a convenient measurement which may be used to find growth stocks that are inexpensive. A stock with a PEG ratio of less than 1 is considered undervalued and it is overvalued if the figure exceeds 1. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.

Let’s take Sarin Technologies (SGX: U77) as an example. As of 3 October 2013, it has a P/E of 19.5 with a projected growth rate of 33.3%. This equates to a PEG of only 0.59, which implies that it might be undervalued due to its exceptional growth rate despite a rather lofty P/E ratio.

In general, the P/E ratio tends to be higher for a company with a faster growth rate. Thus, by just valuing high-growth companies using the P/E ratio only would make them appear overvalued relative to others stocks. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio might be better for comparing companies with different growth rates.

Limitations Exist

Although the ratio may be used as a quick way to assess and value companies, many limitations do exist. Among these are:

  • The ratio is based on projected EPS growth. However, it is not always accurate especially if future growth rates are expected to deviate from its historical growth pace.
  • It does not account for dividends, a substantial contributor to total returns.
  • It punishes low-growth stocks such as mature but stable blue chips. One example is Singpost (SGX: S08) where it churns out regular dividends amid a slower growth environment.
  • PEG ratios are considered less useful in assessing cyclical stocks as profits and share prices of cyclical companies tend to follow the ups and downs of the economy. Noble Group (SGX: N21) is one good example as its business operations revolve around commodity prices, which tends to go hand-in-hand with how well the economy is doing.

Foolish Bottom-line

People often use the PEG ratio as a simple and quick valuation method. However, it should be noted that the popular blue chips have performed well in spite of their high PEG ratios. Therefore, investors should not use any single evaluation tool as a decision maker. Instead, it is vital to analyse a company from different angles for a better picture.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo owns shares in Noble Group as mentioned.