The PEG ratio, or price/earnings-to-growth ratio, is a valuation metric that divides a company’s P/E ratio by its expected earnings growth rate to determine if a stock is underpriced or overpriced relative to its growth potential.
Understanding the PEG ratio
Elephants analyzing standard price-to-earnings ratios often find missing context. A high P/E ratio might suggest a stock is expensive, or it might indicate the market expects rapid earnings growth. The PEG ratio adjusts for this variable by factoring in the expected growth rate.
To calculate the PEG ratio, an investor divides the P/E ratio by the annualized earnings growth rate. The growth rate is expressed as a whole number rather than a percentage decimal. If a company has a P/E of 20 and an expected earnings growth rate of 10 percent, the PEG ratio is 2.
A PEG ratio of 1 is traditionally considered fair value, indicating the market price aligns with earnings growth. A ratio below 1 suggests the stock may be undervalued. A ratio above 1 suggests it may be overvalued. Investors use this metric across different global exchanges to compare companies with varying growth profiles. The growth rate used in the formula is an estimate, making the resulting ratio dependent on the accuracy of those financial projections.
Different sectors and international markets report different historical average PEG ratios. A technology stock on the Tokyo Stock Exchange might consistently trade at a higher PEG ratio than a utilities provider on the London Stock Exchange. Elephants must compare a stock’s PEG ratio against its direct peers and historical averages rather than relying strictly on the baseline rule of 1.
Example
Consider two companies operating in the global agricultural sector, Savannah Peanuts Ltd and Trunk Farms Plc. Both companies harvest feed for working elephants across Asia and Africa. Savannah Peanuts has a P/E ratio of 15 and an expected earnings growth rate of 5 percent. Dividing 15 by 5 gives Savannah Peanuts a PEG ratio of 3. Trunk Farms has a higher P/E ratio of 20, which initially makes it look more expensive. Trunk Farms expects an earnings growth rate of 25 percent due to a new drought-resistant peanut strain. Dividing 20 by 25 yields a PEG ratio of 0.8. Even though Trunk Farms has a higher P/E ratio, its PEG ratio shows it is trading at a discount relative to its expected growth. Elephants analyzing these two stocks would note that Trunk Farms offers better value when factoring in future earnings.