Investors are used to looking at the past to understand the future better. So much of our fundamental and technical analysis looks at past patterns and data; we hope the same patterns will repeat.
Backward-looking metrics aren’t the only ones available for investors. For example, one future-looking metric called the Price/Earnings-to-Growth (PEG) ratio was popularized by the legendary investor Peter Lynch.
He was a fund manager at Fidelity, averaging an annual return of 29.2%. The PEG ratio considers the future expected growth of a public company. As with all ratios, there are pros and cons. We will explore them later in this article. We will also compare the PEG ratios across various sectors. This might allow us to identify undervalued stocks as more attractive than their peers. Let’s begin.
To begin with, how do we obtain the PEG ratio? First, calculate the P/E ratio by dividing the stock’s price by its earnings per share (EPS) to obtain the P/E ratio. Then, divide that amount by the expected EPS growth over a selected period.
Most analysts use a one, three, and five-year period. The further you go on the timeline, the bigger the margin of error can become. No company is safe from unexpected externalities such as a pandemic, climate change, or war.
The slightest event can disrupt the most precise calculations. However, for those who don’t want to calculate this manually, most websites like Yahoo! Finance, Marketwatch, or even your broker will have the PEG ratio at your disposal in a few clicks.
Future growth rates can be obtained in many ways. After an earnings call, the company will often issue guidance about its future operations and growth in the upcoming quarters. Those are the expected growth rates for a forward PEG.
On the other hand, analysts can use historical growth rates to obtain a trailing PEG. If the company doesn’t expect growth in that timeframe, there can’t be a PEG ratio.
What Does the PEG Ratio Mean?
The PEG ratio tells investors if a stock is expensive relative to its growth rate. One major advantage of the P/E ratio is the adjustment for growth. When the ratio gives 1, the stock is fairly valued. When it is below 1, the stock is undervalued. On the other hand, over 1 means overvalued. Various industries and company types have different PEG ratios.
Many tech stocks have had a ratio well above their peers in the last decade. This distorted the ratio across other industries. Assuming the growth expectations are correct, the rule of thumb is a ratio below 1 is desirable.
The next section will look at a fictional example with two stocks.
Price per share = $50
EPS this year = $2.2
EPS last year = $1.8
Price per share = $85
EPS this year = $2.7
EPS last year = $1.8
Thanks to the information above, we can calculate the information below. Then, we can compare the results between both companies.
P/E ratio = $50 / $2.2 = 22.72
Earnings growth rate = ($2.2 / $1.8) – 1 = 22.2%
PEG ratio = 22.72 / 22.2 = 1.02
P/E ratio = $85 / $27 = 31.48
Earnings growth rate = ($2.7 / $1.8) – 1 = 50%
PEG ratio = 31.48 / 50 = 0.6296
Despite having a lower P/E ratio than company B, company A has a higher PEG ratio. Which company is more attractive to investors? The answer is company B. Compared to its growth rate, it is trading at a discount. Investors are paying less for each unit of growth. These numbers are for a fictional company based on growth over one year.
PEG Ratio Pros & Cons
Pros: The most significant advantage of the PEG ratio is that it factors the growth rate in its calculation. Investors can’t always assume past performance will be replicated. A company’s growth depends on several factors; they can change as we progress.
Cons: However, we can only speculate about the growth rates. Using the same logic, they can change depending on different market conditions. Therefore, forecasting the growth over several years is much more difficult than projecting ourselves 12 months ahead.
Comparing PEG Ratios Across Various Sectors
Across the 11 sectors of the stock market, the average PEG ratio differs.
Basic Materials: 0.86
Consumer Cyclical: 0.97
Communication Services: 1.22
Real Estate: 2.57
Consumer Defensive: 2.77
Let’s look at some top companies by market cap in a few sectors.
Exxon Mobil: P/E = 10.3; PEG = 0.41
Chevron: P/E = 15.34; PEG = 0.76
Nextera Energy: P/E = 34; PEG = 3.58
Exxon has the smallest P/E and PEG ratio of these three companies, the only one below the industry average. It is also the best-performing stock among all three. The energy sector is very volatile, and growth periods are scattered. This year, most stocks in this sector performed well above expectations due to a shortage of supply caused b the war between Russia and Ukraine.
JPMorgan Chase: P/E = 9.27; PEG = 1.85
Bank of America: P/E = 12.8; PEG = 1.54
Wells Fargo: P/E = 11.04; PEG = 1.04
The top 3 companies by market cap have mixed results in the financial sector. They have had negative stock performance in the last 12 months, but Wells Fargo has the best among the three. After all, it has the best PEG ratio and is significantly below the industry average.
Apple: P/E = 27.68; PEG = 1.48
Microsoft: P/E = 28.59; PEG = 1.48
Alphabet (Google): P/E = 21.54; PEG = 1.78
As mentioned, tech stocks have some of the highest P/E and PEG ratios across all industries. This is because they are some of the most valuable companies in the world. With so much cash on hand, they have huge growth potential. It isn’t easy to pick a winner among the three stocks mentioned above. Apple and Microsoft are both very similar and are below industry averages. They have been long-term rivals and will remain so for decades to come.
Now You Know What the Price/Earnings-to-Growth (PEG) Ratio Is
The PEG ratio is useful for investors who can accurately calculate a stock’s growth. However, it isn’t easy, and many variables must be considered. Moreover, the PEG ratio should never be the only metric to consider. It is always best to use a mix of fundamental and technical analysis. Plenty of tools are available for an accurate global view of a public company. In today’s market, any event can shift the anticipated growth in any direction.
If you want to learn more about profiting from the stock market, head to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.