Share Market

The market is usually more concerned about the future than the present; it is always looking for some way to figure out what is going to happen in the company’s future. A ratio that will help you look at future earnings growth is called the PEG ratio. You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

PEG = (P/E) / (projected growth in earnings)

For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of

30 / 15 = 2.

Technically speaking: The lower the PEG number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value. In other words, one is interested with stocks that have a low PEG value.

To figure this out, you look at the PEG ratio. Now, if the PEG ratio is big (or closes to the P/E ratio), you can understand that this is probably because the “projected growth earnings” are low. This is the kind of stock that the stock market thinks is of not much value. On the other hand, if the PEG ratio is small (or very small as compared to the P/E ratio, then you know that it is a valuable stock) you know that the projected earnings must be high. You know that this is the kind of fundamentally strong stock that the market has overlooked for some reason.

A PEG ratio of 1 is normally seen as fair valuation and anything above that is expensive. However, one of the biggest drawbacks of PEG is with respect to the surety of the growth in earnings in the long-term. What if the expected earnings growth does not materialise? Also, one cannot use PEG for all sectors. Take the case of the steel sector. The industry is cyclical in nature. In times of a downturn, the P/E ratio gets inflated due to lower earnings. As a result, the PEG ratio may not accurately reflect as to whether the investment is attractive or not, particularly if the markets expect the company’s earnings to remain subdued, going forward. Similarly, in an upturn, the P/E ratio tends to be lower due to considerably higher earnings and accordingly, the PEG ratio may seem lower if the markets expect the company to maintain strong earnings momentum.