The PEG (Price/Earnings to Growth) ratio is a tool that can help investors find undervalued stocks. It’s not as well known as its “cousins,” the P/E and P/B ratios, but is just as valuable.
When used in conjunction with other ratios, it provides investors a perspective of what the market thinks of a stock’s growth potential relative to Earnings per Share (EPS) growth.
The PEG ratio compares a stock’s Price/Earnings (P/E) ratio and its expected Earnings per Share (EPS) growth rate.
If the PEG ratio is equal to 1, it means that the market is pricing the stock to fully reflect the stock’s EPS growth.
Which is “normal,” in theory, because the P/E is supposed to reflect a stock’s future earnings growth in a rational and efficient market.
If the PEG ratio is great than 1 it could indicate that the stock is overvalued or that the market expects future EPS growth to be greater than what is currently the consensus number.
Growth stocks typically have a PEG ratio greater than 1 because the investors are willing to pay more for a stock that is expected to grow rapidly – otherwise known as “growth at any price.”
Or it could be that the earnings forecasts have been lowered but the stock price remains relatively stable for other reasons.
If the PEG ratio is less than 1 it could be a sign of an undervalued stock or that the market does not expect the company to achieve the earnings growth that is reflected in the estimates.
Value stocks usually have a PEG ratio less than 1 because the stock’s earnings expectations have risen and the market has not yet recognized the growth potential.
On the other hand, it could also indicate that earnings expectations have been reduced faster than the issue of new forecasts.
It is important to note that the PEG ratio cannot be used in isolation …
Like all financial ratios; in order to properly use PEG ratios investors must use additional information in order to get a clear perspective of the investment potential of a company.
Investors must understand the company’s operating trends, fundamentals, and what is reflected in the expected EPS growth rate.
Additionally, the P/E and PEG ratios must also be analyzed in relation to its peer group and the overall market in order to determine if the stock is overvalued or undervalued.