If you are looking for growth shares to invest in then the PEG Ratio is an invaluable tool but many beginners to share investing have never heard of a PEG Ratio or, if they have, they have little idea of what it is or how they can use it to improve their share investing.
Finding companies and shares that are attractively priced is always a problem for share investing beginners.
The PEG ratio is another method that can be used and is less well-known.
I use it all the time, in conjunction with the other methods, as a means of helping me to decide whether a share that I am interested in is available to buy at a low price.
So allow me to introduce you to the PEG Ratio…
What Is PEG?
PEG is an abbreviation for Price to Earnings Growth and is a way of comparing a company’s share price to its earnings growth.
At first glance, this sounds a lot like a Price to Earnings Ratio (PE Ratio) and you would be right, sort of.
They are similar and very closely related in that both deal with share price and earnings.
But they do it in different ways, as we will see now.
What is a Price Earnings Ratio?
The Price Earnings Ratio is also known as the Price to Earnings Ratio or PE Ratio.
To save time and space in this article, if you are not yet familiar with the PE ratio then please read my article about it before going any further.
Whilst the PE ratio is extremely useful, when comparing one company’s shares in a sector against its competitors, it can make fast growing companies seem expensive.
When the reality could actually be that the shares are undervalued.
The problem comes with the one-dimensional nature of the PE ratio because it is just comparing against the earnings of one year only.
If we use this year’s earnings to calculate the PE ratio, then we have the current PE ratio.
If we use the earnings forecast for next year to calculate the PE ratio, then we have the prospective PE ratio.
If the earnings are growing, then we would expect the prospective PE to be lower than the current PE when we calculate the two numbers.
Whilst this sounds good, we are not much closer to knowing whether the share price is overvalued or undervalued on this basis.
To understand this better, let’s look at an example.
PE Ratio Examples
Let’s say the share price of Company A is 120p per share.
The published earnings for the current year (just gone) are 10p per share (EPS = 10p), giving us a current PE ratio of 120 / 10 = 12 times.
The forecast earnings for the next year are 12p per share (EPS = 12p), giving us a prospective PE ratio of 120 / 12 = 10 times.
So, if the earnings grow from 10p to 12p as the analyst’s forecast anticipate, the PE ratio will fall from 12 this year to 10 next year, assuming the share price stays the same.
Obviously, what we are hoping is that the PE ratio will stay the same next year due to a rise in share price from 120p to 144p (because 144 / 12 = 12 times).
All well and good, but is this a better buy than its competitor, company B, on a current PE ratio of 11 this year and 10 next year?
At first glance you might say that company B is a better investment than company A because its PE ratios are lower?
Let’s take a look at the data for company B, then.
Let’s say that the share price of Company B is 110p per share.
The published earnings for the current year are 10p per share, giving us a current PE ratio of 110 / 10 = 11 times.
The forecast earnings for next year are 11p per share, giving us a prospective PE ratio of 110 / 11 = 10 times.
Which share would you buy, Company A or Company B?
If you are not sure, what is the piece of data that you are missing?
Earnings Growth Rate
We have all the data above, but we need to do something else with it in order to decide which is the more attractively priced share.
We need to know how fast the earnings are growing for each of the companies.
In other words, we need to know their Earnings Growth Rate.
So let’s do that now using the data from earlier.
Company A’s earnings is forecast to grow from 10p to 12p which is a percentage growth of (12 – 10) / 10 = 0.2 = 20%.
Company B’s earnings is forecast to grow from 10p to 11p which is a percentage growth of (11 – 10) / 10 = 0.1 = 10%.
So, Company A is growing twice as fast as Company B.
So what now?
PEG Ratio Calculation
The PEG ratio is defined as:
The prospective Price To Earnings Ratio divided by the prospective Earnings Growth Rate in percent
The PEG therefore gives us a way of comparing the PE ratio to the amount of growth in the company.
In other words, if the growth rate of the company is higher (growing faster) then we would expect the PE ratio to be higher because we would expect to pay more for the company’s shares.
PEG Ratio Examples
Using our data from earlier, Company A has a PEG ratio of 10 / 20 = 0.5 times.
Company B has a PEG ratio of 10 / 10 = 1.0 times.
So the PEG ratio of Company A is lower than that of Company B which tells us that its shares are more attractively priced than Company B’s.
Now you might think you could have come to this conclusion without the PEG, just by looking at the growth rate of Company A compared to Company B.
If the prospective PE ratio of Company A had been 25, compared to Company B’s prospective PE ratio of 10, then Company B would now be the better buy.
Notice that in this case, the PEG for Company A would be 25 / 20 = 1.25 times compared to a PEG of 1.0 for Company B.
The PEG Ratio is a Valuation Tool
As we’ve seen in this article, the PEG ratio is another method you can use to value company shares and compare one buying opportunity with another.
The PEG ratio is great for valuing growth shares.
But it is no good for shares where earnings are falling from year to year.
Like the PE ratio, it is no good either for shares with zero or negative earnings.
But that’s a whole new subject for another article!
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