The price/earnings-to-growth ratio (PEG) is an indicator used to show the price-to-earnings ratio (P/E) of a stock in relation to its long-term growth. This provides a more accurate picture of the stocks actual P/E ratio.
One of the biggest lacks of the P/E ratio is the fact that it does not account for profit growth. Investors which compare stocks in the same field solely on the basis of the price-to-earnings ratio typically invest in stocks with a low P/E ratio because their potential earnings seem promising.
However, some companies grow at a much faster rate than others. Because of this, a company with a high P/E ratio may in fact show exceptionally fast growth, which generally leads to growth in stock value. These circumstances are accounted for by the PEG.
To calculate a PEG, you divide the price-to-earnings ratio (P/E ratio) by the companies projected growth rate (as a percentage). The expected growth in profitability is normally based on the previous year’s growth rate.
If a company’s stocks have a P/E ratio of 15 and the company’s anticipated growth rate is 25 percent, the PEG of those stocks would be 0.6 (=15/25). Generally, a PEG of less than 1 is considered good value, while stocks with a PEG of more than 1 are rated as expensive.
However, it is important to consider that past growth is not a fail-proof indicator of a company’s future profitability. Growth rates are subject to cyclical fluctuations and vary widely between branches.
Because of this, you need to make a clear projection of whether or not the industry in question will grow and if so, whether or not a company will maintain its growth phase.