PEG Ratio

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What is the PEG ratio?

The P/E ratio is a common measure of relative value of equities based on their earnings per share (TTM). Equities with a high P/E ratio suggest a market consensus that the firm has strong future earnings growth prospects. Because the P/E ratio does not reflect future earnings growth, we use the PEG ratio to determine whether the market valuation is supported by the predicted future earnings growth rates.
 

Origin of the PEG ratio. History

The PEG ratio was developed to address shortcomings in the use of the P/E ratio. Specifically, it was created to adjust the P/E ratio for relative projected future earnings growth rates of different firms.

Calculation of the PEG ratio. Formula

PEG ratio = (Market Price / Earnings Per Share) / (Predicted Annual Growth in Earnings)

Usage of the PEG ratio. Applications

• Portfolio managers and analysts commonly compare PEG ratios to identify undervalued and overvalued equities.
• A common application is applied to emerging market equities (where earnings growth rates are high and uncertain). As a general rule of thumb, when the PEG ratio is approaching a value of 1.0, the firm's equity is considered "fairly" valued. If the PEG ratio is less than 1.0, the equities are considered "undervalued". If the PEG ratio is greater than 1.0, the equities are considered "overvalued".
• Since the market tends to price equities relative to their sector, a meaningful comparison of PEG ratios (and P/E ratios) demands viewing them against the sector or industry average.

Steps in the PEG ratio. Process

1. Determine the firm's current market price per share (price of equities).
2. Determine the firm's most recent published Earnings per Share (trailing twelve months).
3. Determine the firm's expected growth in Earnings per Share (use the longest, reliable estimate available, preferably 2+ years).

Strengths of the PEG ratio. Benefits

• The PEG ratio provides a simple and reliable valuation "rule of thumb". If fully and fairly valued, a growth equity should present a P/E ratio equal to the percentage growth rate of the Earnings Per Share (EPS) of the firm.

Limitations of the PEG ratio. Disadvantages

• High risk companies trade at lower PEG ratios than low risk companies with comparable growth rates.
• High growth firms trade at lower PEG ratios compared to average (or low) growth firms.
• Firms investing less in high quality projects and with high reinvestment rates demonstrate higher PEG ratios.
• The PEG ratio is sensitive for the interest rate. A decrease (increase) of the interest rates is resulting in fewer (more) equities appearing to be undervalued.
• While the firm matures, the PEG ratio will be affected by the firm's changing risk, dividend and reinvestment profile.
• The PEG ratio of comparable firms will be affected by the composition of the firm (i.e., business mix, risk and growth profiles).
• Firm's paying significant dividends require a derivative of the PEG ratio, the PEGY ratio = PE / (Projected Annual Earnings Growth + Dividend Yield).
• In industries where equities are valued on factors other than earnings (e.g., asset-based firms), the P/E ratio is not accurate in reflecting growth rates.
• Finally, intrinsically, there is no fundamental basis for concluding that a firm's equities are undervalued or overvalued, based solely on the PEG ratio.

Assumptions of the PEG ratio. Conditions

• The PEG ratio assumes the P/E ratio and earnings growth rate reflect a consistent base year and forecast period.

Book: Damodaran, Aswath - Investment Valuation: Tools and Techniques

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Compare with the PEG ratio: P/E ratio  |  PEGY ratio  |  Relative Value of Growth  |  Economic Value Added  |  Market Value Added  |  CFROI  |  CAPM  |  EBIT  |  EBITDA  |  Economic Margin  |  Return on Equity  |  TSR  |  PRVit

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