Valuation Multiples - PEG Ratio

We are going to run through a few valuation multiples in the next few posts that are used to compare different companies, and the different strengths and weaknesses of each multiple for analysing companies. The ratios we will look at are the P/E, P/B, P/Sales, PEG and EV/EBITDA ratios. The next ratio up is the PEG Ratio.

PEG Ratio

The PEG ratio is calculated as the PE ratio divided by the % growth rate in earnings of the company. So for instance if the PE ratio is 10 and the company has aconsistent 10% earnings growth rate, then the PEG ratio of the company is 1. In general the PEG ratio is calculated using a forward PE ratio and the projected growth rate, so it is an estimate, not a historical value. The PEG ratio is generally used in the same way as  PE ratio, in that a low PEG ratio is generally considered to be an indication of better value. A low PEG ratio indicates that less of the potential earnings growth in a stock is priced in. Alternatively a high PEG ratio indicates that the potential growth in a stock is fully priced in. In general companies with a PEG ratio less than 1 are considered to be high value.

Advantages of the PEG ratio include:

  • Some stocks with high PE ratios may still be good value because their potential growth in not priced into the stock. The PE ratio will report these stocks as expensive on a relative basis when they may well be relatively cheap.
  • Most valuation ratios do not emphasise the growth rate in earnings or cash flow, whereas this is basically the focus of the PEG ratio. Given most investors will invest in equities in order to get exposure to growth in income, this ratio is significantly more relevant than other ratios that just contemplate either current earnings or sales or book value.

Disadvantages of the PEG ratio include:

  • It is reliant on an estimate of earnings in the future and an estimate of long term earnings growth. As such the ratio is not exact.
  • Distressed companies will generally report high PEG ratios so a low PEG ratio may just be an indication that the company is in danger of going broke (and therefore be justified based on the high risk).
  • The amount of work required in order to calculate a PEG ratio accurately is much more than for historical PE, PS and PB ratios which can be calclated by simply looking up data in annual reports.