PEG Ratio - PEG As An Indicator

PEG As An Indicator

PEG is a widely employed indicator of a stock's possible true value. Similar to PE ratios, a lower PEG means that the stock is undervalued more. It is favoured by many over the price/earnings ratio because it also accounts for growth.

The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns. The PEG Ratio can also be a negative number, for example, when earnings are expected to decline.This may be a bad signal, but not necessarily so. Under many circumstances a company will not grow earnings while its free cash flow improves substantially. Here, as in other cases, analyzing the components of PEG becomes paramount to a successful investment strategy.

The PEG ratio is commonly used and provided by various sources of financial and stock information. The PEG ratio, despite its wide use, is only a rule of thumb and has no accepted underlying mathematical basis. Its specific mathematical deficiency is explained here.

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; this is 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 and perhaps a more realistic PEG ratio.