As we all are aware that P/E ratio is not a very reliable and assuring indicator for assessing the valuation of a stock. There are many strings attached to this ratio and many a times investors becomes confused on how they can ascertain the true value of the stock they are purchasing. Hence, an enhanced ratio called the PEG ratio helps to buy best stock for your portfolio.
In case, you have missed my article on P/E ratio, do follow the below link to get a much fairer idea on P/E ratio:
How P/E ratio helps you to buy best stock in the stock market?
So, came another ratio which is considered to be a more accurate measure to estimate the value of a stock. It is called the PEG ratio. It was coined by Peter Lynch and the only major change which he did to the P/E ratio is to associate it with the annual growth. PEG stands for Price/Earnings to Growth ratio. It is the ratio of the P/E ratio to the long-term compounded annualized percentage growth rate of earnings, conventionally for the next five years’ worth (EPS growth rate).
Thus, PEG = P/E ratio / Annualized Growth or EPS growth
This ratio has better potential to reveal the true value of a stock since growth of a firm is also considered. Nevertheless, it is always advisable to determine the P/E ratio as well as PEG to ascertain the valuation of a stock.
How are PEG measured?
Earnings growth is a very vital parameter in determining the prospect of a stock. Investors are interested to buy stock only if they are confident of a future growth potential of a stock. As such, PEG is believed to be a reliable indicator.
It is generally assumed that if the PEG of stock lies between 0 to 1, then the stock is undervalued and has much better prospect to grow in future.
PEG with value more than 1 is generally considered overvalued stocks.
One good thing about PEG is that the general rule for calculating PEG is followed for all the sectors and does not ask you to discriminate its ratio sector wise. This general rule makes it easy to determine value of stock from varied sectors.
Illustration:
Let us take the example of Aurobindo Pharma. The market price for Aurobindo Pharma is 870 INR and its EPS is 48.78. Then, by the formula, its P/E ratio will be 870/48.78 which comes to around 17.84. Its annualized growth is around 88.24 %. By formula is PEG will be 0.20 which is less than 1 and hence this stock is undervalued.
Now, consider the share price of RIL which is around 1033 INR. Its EPS is 68.89. Then, by the formula, its P/E ratio will be 1033/68.89 which comes to around 14.99. Its annualized growth is around 4.26%. By formula is PEG will be 3.51 which is more than 1 and hence this stock is overvalued.
Caution: This is just an illustration to show PEG can be used for knowing the value of the stock. Your stock market decisions are at your own risk and this website does not hold any responsibility for that.
How PEG is more accurate (or better) than P/E ratio?
Let us take an example to understand how PEG is a better measure. We will take the example of JB Chemicals. The market price for JP Chemicals is 246 INR and its EPS is 9.42. Then, by the formula, its P/E ratio will be 246/9.42 which comes to around 26.11 which means it is a high growing stock. But on another note its annualized growth is around 70.86 %. By formula is PEG will be 0.37 which is less than 1 and hence this stock is undervalued when you compare its growth return. Thus, we can easily see that although the P/E ratio doesn’t favor the stock valuation but when you bring in the growth prospect its value is much lesser than the price that it is holding currently. No doubt, PEG gives more precise value of a stock.
Things to Note: Take Aways
1. PEG in the range between 0-1 indicates undervalued stock.
2. PEG in the range more than 1 indicates overvalued stock.
3. The lesser the PEG, the better the bargain on the price of the stock.
4. PEG ratio does not vary with sectors. It is followed the same for all the sectors.
5. Do not buy stocks that have negative PEG ratio. Negative PEG ratio indicates either the current earnings are negative or future earnings are going to decline unless some drastic damage control is undertaken by the company. So, it is better to avoid such stocks.
6. A company whose stock has high P/E ratio might also have very high annualized growth. Do check PEG in such cases. It will help in finding the gems of stock market.
7. PEG ratio are ideal to determine the valuation of a stock of a company that have some growth potential. However, large organizations tend to stabilize their growth over time. So, their growth rate may be lower than P/E. This doesn’t make these large firm stocks not worth buying. In such cases, this indicator is not that useful.
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