The PEG ratio is considered by many investors to be superior to the P/E ratio because it factors in the growth of a company into the analysis.
The PEG ratio is calculated by the P/E ratio divided by the annual EPS growth. The numbers used for the annual EPS growth can be varied and include; predicted growth, trailing growth or growth over a number of years.
Using the PEG ratio can give a different perspective to the value of a share. For example:
- A company with a P/E ratio of 30 and growth rate of 25% would have a PEG ratio of 1.25.
- A company with a P/E ratio of 35 and growth rate of 40% would have a PEG ratio of 0.825.
If an investor was to use the P/E ratio alone, logic would say the first company is better value. However, the PEG ratio actually indicates the second company is better value because it suggests that it is trading at a discount to its growth rate.
A PEG ratio of 1 is believed to present a balance between cost and expected growth – suggesting it is fairly valued. Anything below suggests a stock is undervalued, and anything above 1 suggests a stock is overvalued.
And remember, it is important to compare PEG ratios on a like-for-like basis with companies in the same sector.