The PEG ratio is an equity ratio that can be seen as a kind of "extension" of the P/E ratio. The PEG ratio puts the current share price in relation to the company's profit, with the aim of being able to make a statement about the current valuation level; simply put: whether the share is too expensive or too cheap. However, looking at the P/E ratio in isolation has the disadvantage that companies with high growth potential (growth stocks) can appear too expensive, as they usually have a very high P/E ratio. While the P/E ratio does not take future growth into account, the PEG ratio relates the P/E ratio to the expected earnings growth over the next few years. In this article, you will learn what the PEG ratio is, what benefits the ratio has and how it can be calculated.
What is the PEG ratio?
"PEG ratio" is the abbreviation for Price/Earnings to Growth Ratio. By dividing the PEG ratio (price/earnings ratio) by the expected earnings growth, a statement can be made about the valuation level of the share.
Calculation of the PEG ratio
To calculate the PEG ratio, you need the following data:
- Current share price
- Earnings per share (EPS)
- Expected EPS growth
Different time periods are often used for the expected earnings growth or EPS growth. The PEG ratio cannot therefore be determined unambiguously and may differ depending on the source used and its calculation. Periods of between one and five years are common.
The formula for calculating the PEG ratio is:
PEG ratio = (Price/EPS) / EPS growth
In German:
Price/earnings growth ratio = (share price/earnings per share) / expected earnings growth
Interpretation of the PEG ratio
As described above, the PEG ratio is intended to help assess whether a stock appears worth buying at the current price or whether it is possibly overvalued or undervalued.
There is no clear value above which a share is considered too expensive, fairly valued or too cheap. However, the number 1 is often used as a rule of thumb. Accordingly, a share with a PEG ratio of 1 would be considered fairly valued, a PEG ratio of less than 1 would indicate a favorable buying opportunity (undervalued) and a PEG ratio of greater than 1 would indicate a too high share price (overvalued).
Like all other equity ratios, the PEG ratio should not be used as the sole criterion for stock selection. However, it can be a very useful indicator as part of an overall analysis.