Investing > Complete Guide to the PEG Ratio

Complete Guide to the PEG Ratio

Looking for more information from the P/E ratio? Say hello to the P/E’s big brother, the PEG ratio. 

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Updated January 09, 2022

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Wouldn’t it be cool if you could see the future of a stock?

While this would make it really easy to make money investing, unfortunately, no one gets to have a crystal ball that shows stock tickers one year from now. The closest thing to a crystal ball we have are financial metrics—and one of the most important ones is the PEG ratio.  

The PEG ratio is very similar to the P/E ratio in that it evaluates the health of a particular company you are interested in investing in. Unlike the P/E ratio, the PEG ratio takes it a step further and actually adds a company’s future growth into the equation. 🚀

This is the perfect answer to your investing problems, but the PEG ratio can go a long way when it comes to helping you pick out the stocks to add to your portfolio. In fact, taking a look at the PEG ratio before you buy a stock can help you avoid buying a disaster of a stock as some investors did when they purchased Norfolk Southern Corp (NSC)

If they had just taken the time to look at the PEG ratio of NSC, they would have known it was a poor and overvalued investment. Before you start going gung-ho on the PEG ratio however, it is important to acknowledge that there are times when it may not give you the right picture of a stock. 

Ready to learn about when and where you should use the PEG ratio? Then keep reading, and we will discuss how the PEG ratio works, how it is calculated, and how it can realistically help you pick the right stocks to buy. 

What you’ll learn
  • What is the PEG Ratio?
  • How Does the PEG Ratio Work
  • PEG Ratio Formula
  • What is a Good PEG Ratio?
  • How to Find PEG Ratios
  • The Problems of the PEG Ratio
  • Conclusion
  • Get Started with a Stock Broker

What is the PEG Ratio? 🤔

PEG ratio stands for price to earnings growth ratio, and it is used to evaluate the value of a certain stock while taking the company’s potential growth into account. This ratio is found by using the P/E ratio and factoring in a company’s growth rate. 

This gives the investor a much better idea as to whether or not they should invest in a certain company than just the P/E ratio alone. You have to be careful, however, as there are a few different ways to calculate the PEG ratio that could result in widely differing answers–giving the investor an incorrect idea regarding a certain stock. 

The PEG ratio is important because when you want to invest in a company, you are likely doing so because you hope the company will grow. After all, this is what will give you a good rate of return on your investment. So if you are looking at a metric like the P/E ratio, which doesn’t factor in the growth of a company, you could be completely misdirected with your investment. 

You can see this when looking at various companies that are struggling. For example, if you take a look at Dropbox (DBX), you will see that for 2021, it had an estimated P/E ratio of 31. In the modern market, this would make DBX a reasonable investment. But if you look at the price charts, they show another story, as the company isn’t slated to turn a profit in the coming years. 

average PE ratio
Despite an average P/E ratio, as of late 2021, DBX is yet to reach the price it had during its IPO. The S&P 500 outperformed it significantly. Image by TradingView.

Therefore, an uninformed investor may have seen the P/E ratio of DBX and placed a hefty investment. A closer look at the PEG ratio could have saved the investor a hefty sum as it would have revealed more about the company and the fact that it isn’t expected to experience growth in the future. 

How Does the PEG Ratio Work? 🏗

The PEG ratio is found by taking the P/E ratio (which is the current of the stock, divided by the company’s earnings per share) and dividing it by the expected growth rate of the company over 5 years. The result of this equation tells you how the market is currently valuing the stock you are interested in.

This means that finding the PEG ratio will tell you if a stock has solid fundamentals. Like the P/E ratio, the PEG ratio is best used when comparing two stocks in the same industry. This is because it is only able to tell you if a stock is overvalued or undervalued, but it doesn’t give you a frame of reference beyond this simple fact. 

For example, say you wanted to consider an investment in Disney (DIS) in March 2021. The PEG ratio at this time was 4.57, indicating that an investment in Disney stock was overvalued, and therefore not a good buy. 

But, if for the same time period, you took a look at the PEG ratio of one of Disney’s main competitors, ViacomCBS (VIAC), you will see that it was 12.19, which is also extremely overvalued. 

VIAC’s intense bull run
Despite VIAC’s intense bull run in March 2021, DIS turned out to be a better investment at the end of the year. Image by TradingView.

This means that if you were looking to get into investing in entertainment, you would have been much better off investing in Disney, even though it had what was considered an overvalued P/E ratio at the time. This is because it was still a better buy (less overvalued) than an investment in ViacomCBS, which showed in late 2021 when it was clear that Disney had outperformed its competitor. 

PEG Ratio Formula 📗

The PEG ratio formula is as follows:

PEG_Ratio_Formula

Where, 

P/E Ratio = Price Per Share / Earnings per Share

And Earnings Growth Rate (EGR) = Earnings Growth Rate Over 5 Years

The top part of this equation is made up of the P/E ratio. The P/E ratio is calculated by taking the current stock price and dividing it by the earnings per share. This number gives you an idea of how valuable it is to own stock in said company (based on its earnings). Don’t worry about calculating this number, as it is widely available on most top investing apps

The second part of this equation is taking the first part and dividing it by the earnings growth rate over 5 years. This number represents how much the company has grown over the past 5 years. Much of the top software for stock analysis will have this data readily available. 

The good news is, you can spend the type to calculate PEG on your own (it only takes a few minutes) but also most stock broker websites additionally feature this number for you. It is just important for you to know where this number comes from for your own understanding. 

What is a Good PEG Ratio? 📈

Before you head out to become the next Warren Buffet, it’s important that you know what qualifies as a good PEG ratio. 

Remember that the PEG ratio is derived from the earnings growth rate of a company over the course of 5 years. This means, that if a company is slated to perform on the market exactly based on how much it costs, that you would get a PEG of 1. Therefore a PEG ratio of 1 is considered good. 

Now, what if there is a company with a PEG of above one? As mentioned in the above examples, Disney once had a PEG of 4.57! And generally, in the stock market world, this is considered a bad PEG ratio (more on why this isn’t always the case later!) and this stock would be considered overvalued. 

Therefore, a PEG ratio of under 1 is the opposite, and would indicate that a stock is undervalued. And when you think undervalued, think on sale! A stock with an undervalued PEG ratio means that a stock is likely to perform better on the market relative to how much it costs—a sub-1 PEG is a positive sign for buyers.  

How to Find PEG Ratios 🔎

Do you like doing things the hard way?

If so, then you will likely find that you enjoy reading financial reports of companies and pulling out your calculator to find the PEG ratios. You might even enjoy reading the end-of-the-year financial statements from your favorite companies to be sure you get the earnings growth rate just right.

For those who enjoy doing things the simple way, the good news is, the PEG ratio can usually be found on most popular stock broker platforms. Even if you don’t have a stock broker platform yet, many of the most popular companies’ PEG ratios can be discovered by googling. 

But of course, the choice is yours—this information is easily accessible and publicly available, so the sources you will use should depend on how convenient they are for you, more than anything else. 

💡 Not ready to use a broker yet? No problem – the top paper trading apps allow you to test out their platforms with virtual funds before risking your capital.

The Problems of the PEG Ratio 🚧

Is the PEG ratio sounding a little bit too good to be true?

Like anything in the stock analysis world, the PEG ratio isn’t perfect and there are many things you need to take into consideration before you begin investing in stocks based on the PEG alone. 

Inaccurate Information ⚠️

Math equations only work when you put the proper information into them. The same goes for the P/E ratio. If you get all your PEG from a reputable, published source, it should tell you where it got the numbers used in the calculation. 

Sometimes, however, a site may not be using numbers from official sources. And if inaccurate information is used, then the PEG ratio will not give you an accurate idea of how the stock is performing. This is why it is important to know how to research stocks and properly read the information that is presented. 

Moreover, most companies don’t release financial statements that frequently. So, it is possible to run across information that’s outdated.

Forward vs. Trailing PEG ⚖️

Besides just worrying about inaccurate information being used, there are some platforms that simply use different information to find their PEG. They may be using future growth rather than historical growth, and this can make a big difference. 

Future growth, or forward PEG is all fine and dandy, except it’s using projected numbers, not numbers the company has actually shown it can maintain. Thus, these numbers can often be a bit inflated by optimism. 

Past growth, or trailing PEG, is a great measure of PEG in a company that has been growing the same way for years. But one random event, say, a pandemic, could throw this number off and give an inaccurate PEG. 

Forward vs Trailing PEG
Like all airlines, Southwest Airlines’ stock crashed in early 2020. Image by TradingView.

One example of this is Southwest Airlines (LUV) that saw its stock earnings and stock price drop in 2020 due to a reduction in flying as a result of the COVID19 pandemic. This damaged their growth rate for the past 5 years, and will affect any future PEG rate calculated because of this bad year.

PEG Doesn’t Include Other Metrics 📊

When evaluating the health of a company you are looking at investing in, there are a number of aspects you need to look at. And one of the main problems with the PEG ratio, is that it won’t show you these aspects.

For instance, the PEG ratio doesn’t show how much cash a company has on hand–which can be a major impact to a company making it through a bad period such as a COVID19 pandemic. Additionally, the PEG ratio doesn’t take into account important socio-economic events that impact stock prices more strongly and suddenly than anything else. 

Just look at Hertz Car Rental. Even before the pandemic, they were amassing debt without cash to pay off creditors. So when something major went wrong (enter global pandemic), they were quick to go under and declare bankruptcy. This is something that the PEG ratio wouldn’t have been able to warn you about. 

PEG is Rough on Slower Growing Companies ⏳

The final difficulty with using the PEG ratio is applying it to slower-growing companies. Some companies just need more time than others to develop.

This doesn’t mean they are bad companies, in fact, they may be great long-term investments. The problem is, they’ll look pretty bad when you take a look at their PEG ratio. All it takes is one look at online retailer behemoth, Amazon, to know that this is true.

stock-level price appreciation
 AMZN only started seeing growth stock-level price appreciation 10 years after it went public. Image by TradingView.

Amazon actually started in 1990. But back then, it was a tiny bookstore run out of Bezos’ garage. It took over a decade for Amazon to take off, and it wasn’t until 2008 that it really began to grow. This means that the PEG ratio for Amazon was likely terrible in the early 2000’s (no substantial growth for 5 years and no prospect of future growth) but still, a small investment in the company would have multiplied by 15x today.

Basically, it’s okay to take the PEG into account as you analyze stocks, but just make sure that you are also taking other aspects, such as current events and cash on the books into account. This way, you will have a more clear picture of the health of a company rather than just a ratio telling you if the stock is over or undervalued. 

Conclusion 📝

Overall, the PEG ratio is a stock measuring metric that is a great way to compare companies and evaluate the value of a particular stock. But don’t forget to do your own in-depth analysis on the side, and double check that all the numbers you have used in your calculations are accurate. 

This way you will be able to use the PEG ratio to your advantage, and apply it when it comes to choosing which stocks to put your hard-earned money into. So next time you can’t decide between two particular stocks, don’t forget to pull out the trusty PEG ratio and put it to good use! 

PEG Ratio: FAQs

  • What is a Good 5 Year PEG Ratio?

    A good 5 year PEG ratio would be any number between 0.5 and 1. PEG ratios below 0.5 are considered to be outstanding. 

  • Is a Higher or Lower PEG Ratio Better?

    The lower the PEG ratio the better, as this indicates that a stock is performing how it should. Generally, most investors look for stock with a PEG right around, or below, 1. 

  • Is a Negative PEG Ratio Good?

    A negative P/E ratio is bad, as it indicates that the company is either losing money, or that they aren’t expected to grow in the next 5 years.

  • What Does a PEG Ratio of 0 Mean?

    A PEG ratio of 0 means that the company is exhibiting no growth and is probably not a wise investment. 

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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