How to Calculate Peg Ratio: Definition & Example

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

In this lesson, we will look at the price/earnings to growth, or peg, ratio of a stock, and show how it can be used to evaluate stock investment opportunities.

Peg Ratio

Steve is a do-it-yourself investor in the stock market and has recently made a few bad calls. He thought he was onto something by focusing on Price/Earnings ratios. After taking a few losses, he realized this didn't provide him with a full picture of how each company performed. This morning he came across an investment evaluation metric called the peg ratio. Let's help explain to Steve what a peg ratio is, what makes it useful, and how it is calculated.

Definition

In order to understand the peg ratio, it is necessary to first understand the price/earnings (PE) ratio. Price/earnings explains the price per share divided by the earnings of the company. A low ratio indicates investors are paying less for a share of the company's earnings, while a high ratio indicates investors value those earnings more. A P/E at the extreme ends of the spectrum can indicate the stock is over or underpriced, which is what Steve was using to make decisions about when to buy and sell.

The peg ratio, or PEG, stands for the price/earnings to growth ratio of a stock. It builds on the PE ratio by incorporating the earnings growth rate. This is the difference between the earnings of a stock in this current time period compared to a recent one. A low peg ratio indicates that investors are buying the growth opportunity in the company at a discount relative to a stock with a higher peg ratio. After all, if earnings continue to rise, the stock will become more valuable in time compared to a company that isn't continuously increasing its earnings. Although there are never any guarantees in investing, this strategy can aid in identifying potentially good deals.

Calculation

Let's say Steve is looking at investing in one of two companies. Below is the needed info for each company:

ABC Inc.

Price per share: $50

Earnings per share: $5

Earnings per share last year: $3

XYZ Co.

Price per share: $40

Earnings per share: $2

Earnings per share last year: $0.50

ABC Inc. Has a PE ratio of 10 ($50 / 5). The growth rate of its earnings is 66.7% ($5 / $3) -1. This gives ABC a peg ratio of 0.15 (10 / 66.7).

XYZ Co. has a PE ratio of 20 (40 / 2) and a growth rate of 300% ($2 / $0.50) - 1. This gives XYZ a peg ratio of 0.07 (20 / 300).

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