Securities For Beginners

Friday, January 27, 2006

Terms Explained - Price/Earnings Growth (PEG) Ratio

After I already explained the P/E ratio, this time I want to explain another ratio that is directly linked to the P/E ratio: The Price/Earnings Growth ratio (PEG).

Many investors consider the P/E ratio to be inaccurate to judge wether a stock is overvalued by the market. The problem with the P/E ratio is that it shows you the premium investors are willing to pay in return to an expected growth of the company and its stock's price. It doesn't show you wether this premium is (too?) high or low compared to other companies in the same sector. To get this information you will need to take a look at the PEG ratio.

The PEG is based on the P/E ratio and the expected growth of a company's earnings and is calculated by dividing the P/E ratio by the expected growth:
PEG = P/E ratio / Expected Growth

Company X
P/E ratio: 20
Expected growth: 10%
Company X's PEG = 20 / 10 = 2

Like with the P/E the companies with lower PEG ratios are supposed to be more attractive than those with higher PEG ratios and there are also differences in the PEG levels depending on the industrie you are looking at.

Although the PEG is a great way to judge a stock's value, it has its own traps you need to consider when using it. The main problem is the expected growth you need to know in order to calculate the PEG. And there it is: It's an expectation, not a given fact that the company will achieve this growth rate. But a lower actual growth rate means a higher PEG and in consequence a less attractive stock - unfortunately you will see this after you bought the stock, i.e. when it's too late to change your decision. For this reason investors are sometimes advised to shave 15% from any growth estimates issued by the analysts to create some kind of protection against analysts' errors.

Further information: Move Over P/E, Make Way For The PEG
Yahoo! Finance: Price/Earnings Growth ratio


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