The PEG ratio is one tool you can use to find undervalued stocks. Here’s how it works

• The price/earnings to growth (PEG) ratio is a metric used by investors when valuing stocks.
• The PEG ratio can give a more complete picture than the P/E ratio because it factors in future growth.
• PEG ratios higher than 1 are generally considered overvalued, while those less than 1 are seen as undervalued.
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If you’ve been involved in investing, you’re probably familiar with using the price-to-earnings (P/E) ratio to decide if a stock is a good buy at its current price. While that’s a useful tool for seeking out stocks that appear to be trading below their fundamental worth, it doesn’t always give the full picture.

Another metric, commonly referred to as the PEG ratio, goes deeper by also taking into account how quickly a company’s earnings are expected to grow. Here’s how it works.

What is the PEG ratio? 

The PEG (or P/E-to-growth) ratio looks at a company’s share price relative to its earnings per share (EPS) and projected earnings growth rate. By factoring in a company’s future growth, some analysts see the PEG ratio as giving a more complete view of a stock’s value, particularly for fast-growing companies.

A P/E ratio on its own is a time-honored metric that investors use to seek out companies that may be trading below their fundamental worth. The basic P/E formula simply divides the current stock price by the company’s earnings per share. So let’s say a company has a P/E ratio of 10. In effect, that means you’d be paying $10 for every $1 of earnings, making it relatively expensive compared with a stock with a P/E of 3, for which you’d be paying $3 for every $1 of earnings.

P/E ratios for fast-growing companies such as tech startups, however, don’t necessarily give the best measure of their valuation. Oftentimes the perceived value in these companies is not in the earnings they’re producing now, but in the potential for future profits. As such, their P/E ratios tend to be high. But that doesn’t necessarily mean they’re too richly valued. By incorporating a company’s growth rate into the valuation equation, some investors see the PEG ratio as a more accurate way to determine valuations for such stocks.

“It gives one an idea of how richly or inexpensively valued a company is relative to its growth prospects,” says Robert Johnson, professor of finance, Heider College of Business, Creighton University, and the founder of Economic Index Associates.

How to calculate the PEG ratio 

To calculate PEG ratio, you first divide the company’s share price by its earnings per share, then divide the resulting figure by its EPS growth rate.

EPS is a metric used by investors to evaluate a company’s profitability on a per-share basis. The higher the EPS, the more profitable a company is. In essence, EPS is determined by dividing a company’s earnings by its total number of shares outstanding. However, there are several ways to calculate EPS, including basic and diluted. The calculation also can be based on either historical or projected earnings.

The EPS growth rate for the purposes of the PEG ratio is a company’s forecasted rate of earnings growth over a period of time. This is based on third-party analysts’ estimates.

What does the PEG ratio tell you? 

Typically investors use the PEG ratio to evaluate whether a stock is appropriately priced, undervalued, or overvalued. 

As a general rule of thumb, a PEG ratio of 1 is considered fairly valued. PEG ratios lower than 1 can indicate that a stock is undervalued, while ratios higher than 1 can indicate that a stock is overvalued.

“P/E ratios vary so widely because of the difference in the earnings outlook of a company, so it doesn’t do well comparing different industries or fundamental stock types,” says Don Kaufman, co-founder at the trading education firm TheoTrade. “Since the PEG ratio normalizes the P/E by dividing it by analyst estimates for EPS growth, you can now compare companies across the spectrum. That makes this measure valuable as an initial filter for finding value companies.”

Keep in mind, however, that what’s considered a “good” PEG ratio will vary depending on the industry. Once you’ve screened out stocks you might be interested in using the PEG ratio, be sure to drill down deeper and compare each one to the average PEG ratio for its industry. A stock with a PEG ratio of 0.9 might look like a good value on the surface, but if the average PEG ratio for companies in the same industry is 0.4, you can probably do better.

Remember that like any other analytical tool, the PEG ratio also has its shortcomings. It’s more useful for evaluating companies with a high growth rate than those with a lower growth rate. Additionally, a company’s growth rate is based on estimates, which aren’t always accurate. For example, in 2018 none of the analyst estimates for earnings growth took into account the pandemic that devastated the economy two years later.

Therefore, while it’s a very useful measure of value, it’s important not to rely on it too heavily in making investment decisions. Instead, incorporate it into a more thorough analysis that includes other financial ratios and takes into account additional factors such as management strength and competition that will help give a more complete view of a stock’s intrinsic value.