Over the next few weeks, this set of posts on basic investing metrics will eventually move into more challenging topics. This week we’ll give a taste of what’s to come. My friend John, a law student, is back to talk about the PEG ratio, which is a pretty useful one to know.
Building on what we’ve discussed the previous two weeks, the PEG ratio takes the P/E ratio and combines it with earnings per share growth rate. The equation for the PEG ratio of a company (from Investopedia) is:
Some investors believe that the PEG ratio is a better indicator than the P/E ratio because it takes into account a company’s estimated future growth. It is traditionally held that, like the P/E, a lower PEG means that a company is a better value compared to its peers. The closer the PEG ratio is to 1, the more fairly valued the company. If the PEG ratio is less than 1, investors think that the stock is undervalued and thus is a good investment. If the PEG ratio is higher than 1, investors believe that the stock is overvalued.
Like all metrics, the PEG ratio can be insufficient and should not be taken as the sole support of an investment decision. There are several ways that the PEG ratio can be misleading. First, it is not often known what annual growth rate the source of information is using when calculating the PEG ratio. Therefore, an investor does not know whether the estimated growth is for one year or up to five years. Second, and most importantly, the PEG ratio relies on estimates of future growth by analysts, who have a reputation for not being very accurate. In the next five years, many things can happen to a company’s earnings growth and financial health. Average investors also do not know what assumptions an analyst is using in his or her calculation. Third, the PEG ratio is best suited for “growth” companies and may give a misleading result when used to compare mature or “value” companies. Dividend income is not included in the PEG ratio, so a mature company that pays a high dividend will not look as attractive as a company that has a higher growth expectations.
In the end, the PEG ratio is just another tool in the toolbox of a savvy investor. It should be used in conjunction with other metrics, and never as a standalone reason to buy a company.