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Fundamental Analysis: Price-Earning-Growth (PEG) Ratio

We talked about the Price-Earning (PE) ratio in our previous post. We discussed its merits and demerits. In order to get a clearer picture of the company going forward we need to also look at company’s earnings growth. This anamoly is addressed by Price-Earning-Growth (PEG) ratio.

PEG ratio is defined as the ratio of PE to the earnings growth of the stock. Earnings growth is typically taken for a five or ten year period. It tells us whether the PE is fair compared to its earnings growth.

A PEG ratio of 1 represents that the stock is fairly valued. Value less than 1 represents undervaluation and value more than 1 represents overvaluation. Its formula is

PEG RATIO = Price Earnings / Annual EPS Growth

What does PEG ratio tell you?

PEG ratio is used to ascertain the true relative value of the stock. Just like low PE ratios lower PEG means the stock is undervalued .Moreover it is an improvement over PE ratios because it takes into account the earnings growth also.

A PEG ratio of 1 indicates that the stock is reasonably valued given its earnings growth rate. It is found that when we do a historical analysis of companies with PEG between 0.5 to 1 they have given good returns.

Advantages of PEG ratio

  • Its very easy to use just simple maths needed to figure out PEG ratio.
  • A company’s high future growth is incorporated in the formula. A high PE ratio does not always mean that an overvalued security
  • It allows analysts and investors alike to compare the valuations between companies with different growth rates

Disadvantages of PEG ratio

  • PEG ratio assumes that the companies grow at a constant growth rate
  • Actually many other variables need to be factored in before estimating the future growth of the company. PEG ratio is not the be all and end all of value investing .
  • It is not suitable for valuing a company with low growth rates. For example a large and established company selling at a PE of 10% with earnings growth expected at just 2% would return a PEG ratio of 5.And so it will be considered overvalued .However dividends are not considered and this kind of return could be very lucrative. Low growth companies are stable and mature and give out consistent dividends.

In order to work around this problem a new variant of PEG ratio evolved called the Price/Earning to Growth and Divident Yield (PEGY) Ratio.

A variant of PEG ratio, PEGY ratio

A PEG ratio is biased towards against low growth firms because the relationship between value and growth is non linear. One variant that has been devised to consolidate the growth rate and the expected dividend yield:

PEGY = PE / (Expected Growth Rate + Dividend yield)

As an example the company has a PE of 15, an expected growth rate of 8%, Dividend yield of 4%

PEG = 15 / 8 + 4 = 1.25

PEGY ratio is more appropriate for valuing companies which pay substantial amount of dividends.

Practical Illustration of PEG ratio

Equity shares of a company called ABC are being traded at $50.Its earnings per share price is $10.The dividend Pay out ratio of the stock is 80%.The face value of the shares is $ 10.Company has expected earnings growth rate of 10%.We are required to calculate PEG and PEGY ratio and analyse the company for its value.

Computation

PE ratio of ABC = Market Price / EPS = 50 / 10 = 5

PEG RATIO = PE / Earnings Growth = 5 / 10 = 0.5

On the face of it Company ABC look quite undervalued. Now lets calculate the PEGY ratio to get a better picture

PEGY RATIO = PE / Earnings Growth + Dividend yield

Dividend yield = Total Dividends / Market Price

Total Dividends = $8 (80% Pay out ratio on $10 face value share)

Dividend yield = 8 / 50 * 100 = 16%

So the PEGY RATIO is

PE / Earnings Growth + Dividend yield = 5 / 10 + 16 = 0.19

After analysing the company using given available information company ABC is undervalued both in terms of PEG as well as PEGY RATIO


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