• HDFC securities
• 10 Mar 2023
• Knowledge Centre

When making investment decisions, it is essential to conduct a fundamental analysis of a company. It determines the fair value of the stock and the company. To do this, an investor needs to consider several different ratios. One of the most comprehensive ratios to consider is the PEG ratio. Let us understand what is PEG ratio in stock market.

What is PEG Ratio?

PEG ratio is short for Price/Earnings to growth ratio. This ratio draws a relationship between a company’s price-to-earnings ratio (P/E ratio) and the estimated earnings growth rate of the company over a period of time.

This ratio is much more comprehensive and can help investors ascertain the true value of a company. It determines a stock’s value while factoring in expected earnings growth. Hence, the PEG ratio provides a larger picture while conducting fundamental analysis.

How is the PEG ratio calculated?

The PEG ratio can be calculated by dividing the P/E ratio by the earning per share growth rate. The PEG ratio signifies the relationship between the P/E ratio and the projected earnings growth rate of the company.

Price/Earnings to growth = (Market price of stocks per share / EPS) / Earnings per share growth rate

If the P/E ratio of a company is 2 and if the EPS is expected to grow at 3%;

Then, PEG ratio = 2/3

PEG Ratio = 0.6

Understanding the PEG Ratio

As an investor, it is crucial to know how to interpret the PEG ratio. Since the PEG ratio takes into account the expected growth of a company, it can help an investor know the fair value of a company.

• If a company’s PEG ratio is 1, it is said to be at equilibrium and is fairly valued.
• A PEG ratio of more than 1 indicates that the company is overvalued.
• A PEG ratio of less than 1 depicts that the company is undervalued.

When the PEG ratio is higher than 1, it means that the company has been overestimated with respect to its potential earnings growth, which means the company is overvalued. While a PEG ratio of less than 1 signifies that there is more potential for growth in the company and that it is undervalued.

However, the PEG ratio takes into consideration only a short time period, such as 1-3 years. Hence, a couple of years of higher growth can overstate the benefit of buying a company that is faster-growing.

The inputs used to calculate the PEG ratio determine its accuracy. The P/E ratio is the most widely used measure, but the PEG ratio improves on it by factoring in estimates of future earnings growth. It provides a wider picture of whether a stock is fairly valued based on its future earnings potential.

While the PEG ratio is not perfect, it is a valuable tool for investors to use when assessing the potential of a stock. Ultimately, investors should use the PEG ratio in conjunction with other analysis tools to make the most informed decisions.