Hello friends. In this blog, we discuss various financial topics. That is why we have launched the ‘Stock Market Terms‘ series. This is the fifth post of that series. The topic of our discussion in today’s post is Price to Earning Growth Ratio. In the previous post, we discussed “Price to Earning Ratio“.
What is PEG Ratio
In the last post, we discussed about PE Ratio which tells us whether the current market price of a stock is cheaper or costlier. But, how to know whether the P.E. of a stock is justified or not? In this circumstance, PEG Ratio or Price to Earning Growth Ratio helps us to decide. PEG Ratio is the comparison of a company’s growth rate with its Price to Earning Ratio.
The idea behind PEG ratio is to check whether the P.E. ratio is symmetrical with the company’s growth rate or not. If a company’s P.E. ratio is incrasing year by year, its growth should also be increased. PEG ratio works as a confirmation for P.E. Ratio.
Formula of PEG Ratio
The formula of PEG Ratio is as below
PEG Ratio = Price to Earning Ratio/Growth Rate of the Company
How to use/interpret PEG Ratio?
Suppose, In 2020, company A had the current net profit Rs. 100, total share 5, hence EPS is (100/5) = 20 and then Market Price was Rs. 10, hence P.E. was (10/20) = 0.50. In 2021, company A had the current net profit Rs. 125, total share 5, hence EPS is (125/5) = 25 and then Market Price was Rs. 12 P.E. was (12/25) = 0.48. In 2022, company A had the current net profit Rs. 150, total share 5, hence EPS is (150/5) = 30 and then Market Price was Rs. 15 P.E. was (15/30) = 0.50.
In the above cases, company A’s growth rate in first year is 25%, in second yar 20%. Hence, company A’s PEG for the first year is (0.48/25) = 0.0192 and for the second year is (6/20) = 0.025.
When the PEG ratio of a stock is less than 1, it is said that the stock is undervalued. When the PEG ratio of a stock is higher than 1, it is said that the stock is overvalued. When the PEG ratio of a stock is equal or around 1, it is said that the stock is fairly valued. Why so? Let’s understand.
P.E. ratio indicates how much premium investors are ready to pay to buy a stock. Investors pay premium to buy a stock based on the projection of the company’s future growth. If a company’s projected growth rate is high, investors pay high premium and vice-versa. In a good company, the PE ratio and its growth rate should go hand in hand. PEG Ratio tells us whether a stock is really undervalued or overvalued or fairly valued. In case of PE Ratio, we can say, it is the value investors are giving based on company’s current and future growth rate. But it does not mean that whatever value investors are now giving to a stock is cent percent correct. This may be understood with the example in Case I. Company A’s growth rate in 2021 is 25%, but its P.E. has grown by only [100*(5-4)/5) = 20%. In this case, we can say that, investors are giving less value to the company equivalent to its growth rate. Thus, we can say that, company A is an undervalued stock. PEG Ratio also confirms this as the PEG ratio comes to less than 1.
However, if the PEG ratio would have come to more than 1, we would say that the stock is overvalued and if around 1, we would say that the stock is fairly valued.
Let us understand this with a real-life example. As of 22.02.22, the PEG ratio of Nestle India is 6.69. This means the stock is overvalued. On the other side, let us see IDBI Bank. The current PEG ratio of the stock is 1.01. This means the stock is fair valued (as it is just above 1). Now, let us see the example of Power Grid Corporation. At present, the PEG ratio of the stock is 0.62. Hence, in terms of PEG Ratio, it is an undervalued stock.
Price to Earning Growth Ratio is a very important valuation ratio. However, while considering the P.E.G Ratio of a stock, one should check all the other fundamental parameters before taking the final decision of investing.
Hopefully, I’ve been able to give you a clear idea about P.E.G. Ratio. Follow us to know all such information about various financial topics and to understand everything in simple language. If you have any questions about this post, please let us know in the comments or mail us at [email protected]. Share this article with others if you found it worthy. In this blog, we publish various articles on finance. To get all the post notifications from this blog, click on the red bell icon on the right side and turn on the notification. Thank you for spending your precious time reading this article. Stay well, stay healthy.