PEG ratio
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The PEG ratio, Price/Earnings To Growth, is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected future growth.
A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that approaches two or goes higher than 2 is believed to be too high. This means that the price paid appears to be much too high relative to the estimated future growth in earnings.
PEG is a widely employed indicator of a stock's possible true value. The PEG ratio of one represents a fair trade-off between the values of cost and the values of growth, then the stock is reasonably valued given the expected growth. Similar to PE ratios, a lower PEG means that the stock is undervalued more. It is favored by many over the price/earnings ratio because it also accounts for growth. If a company is growing at 30% a year, then the stock's P/E could be as high as approximately 30. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns</ref>http://www.fool.com/investing/value/2006/04/06/how-useful-is-the-peg-ratio.aspx How Useful Is the PEG Ratio?</ref>.
The PEG ratio is commonly used and provided by various sources of financial and stock information. The PEG ratio is only a rule of thumb despite its wide use, and has no accepted underlying mathematical basis; the PEG ratio's validity at extremes in particular (when used, for example, with low-growth companies) is highly questionable. It is generally only applied to so-called growth companies (those growing earnings significantly faster than the market).
When the PEG is quoted in public sources it may not be clear whether the earnings used in calculating the PEG is the past year's EPS or the expected future year's EPS; it is considered preferable to use the expected future growth rate.
It also appears that unrealistically high future growth rates (often as much as 5 years out, reduced to an annual rate) are sometimes used. The key is that management's "expectations" of future growth rates can be set arbitrarily high; a self-serving ploy, where the objectives are to keep themselves in office, and to make the stock artificially attractive to investors! A prospective investor would probably be wise to check out the reasonableness of the future growth rate, by checking to see exactly how much the most recent quarter's earnings have grown, as a percentage, over the same quarter one year ago. Dividing this number into the future P/E ratio can give a decidedly different PEG ratio, and perhaps a more realistic one.
Advantages
Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.
Disadvantages
The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.
A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, and hype of investors.
The convention that (PEG=1) is appropriate is somewhat arbitrary and considered a rule of thumb metric. Mathematically, growth that is faster than growth of the economy cannot be infinite (or the company would eventually become larger than the economy), and the PEG ratio does not account for the period of time that faster-than-normal growth will continue. In addition, there is no implicit or explicit correction for inflation (i.e., a company with growth equal to the rate of inflation is not growing in real terms). Hence, the PEG ratio lacks a coherent conceptual framework, and is used primarily as a somewhat intuititive metric of the extent of the growth/price trade-off.
At extremes, and particularly for low-growth companies, the PEG ratio implies valuations that may appear to be nonsensical. For example, the PEG ratio "rule of thumb" implies that a company with 1% growth in earnings per annum should have a P/E ratio between 1 and 2, a level that would appear to be extremely low. For companies with zero expected growth, the ratio is undefined (division by zero), and for companies with negative growth, the result (a negative PEG ratio, for example) may be meaningless.
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