Trillionaire Term of the Day - January 30, 2009 - PEG Ratio

Price/Earnings to Growth (PEG) Ratio

The PEG ratio is a ratio used to determine a stock’s value while taking into account earnings growth.  The PEG ratio is actually the more in-depth and telling version of the P/E ratio, as it compares a company’s P/E ratio to its projected earnings growth (to learn about P/E ratios, see the Trillionaire Term of the Day for January 7^th, 2009).  The calculation to find the PEG ratio is:

Price/Earnings Ratio

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Annual EPS Growth 

The PEG ratio takes into account the fact that a company with a higher P/E ratio is usually growing at a faster pace, and it shows that companies with high P/E ratios are not always overvalued.  So, the PEG ratio is a much better method of comparing companies with different growth rates.  According to Peter Lynch, a very famous investor, “The P/E ratio of any company that’s fairly priced will equal its growth rate.” This quote essentially says that a fairly valued company will have a PEG ratio of 1.  For example, if a company has a P/E ratio of 15 and is growing its earnings at a 15% rate, this company would be fairly valued because its PEG ratio would be 1. 

Another conclusion we can make from this equation is that a lower PEG ratio is better/cheaper and a higher ratio is worse/expensive.  For example, a company with a P/E ratio of 10 that is growing its earnings at a 20% rate will have a PEG ratio of .5.  This PEG ratio of .5 is basically saying that the company’s earnings are growing two times faster than people are giving it credit for.  On the other hand, if a company had a P/E ratio of 30 and was growing its earnings at a 15% rate, the company’s PEG ratio would be 2.  This company would be considered overvalued and expensive, as investors are paying 30 times earnings, while earnings are growing only at a 15% rate. 

Let’s do a real-world example, and let’s compare two internet companies, Yahoo (YHOO) and Google (GOOG).    Yahoo currently has a 38.71 P/E ratio, meaning that investors are paying 38.71 times the company’s earnings for the stock.  But the company is only expected to grow earnings around 18.25% in the next five years.  Thus, the PEG (5 yr) ratio for Yahoo is 2.12 (38.71/18.25).  Google currently has a 25.43 P/E ratio, and the company is expected to grow earnings around 29% over the next five years.  Thus, the PEG (5 yr) ratio for Google is .88 (25.43/29).  So what do these numbers tell us about both Yahoo and Google? First, just by looking at the P/E ratios, we can tell that Yahoo is more overvalued than Google, as its P/E ratio is 38.71 compared to Google’s 25.43.  But, is Yahoo’s higher P/E ratio justified by a higher growth rate.  The answer is no, as Google is expected to grow its earnings 29% over the next five years, and Yahoo is only expected to grow 18.25%.  So, it seems that Yahoo is definitely more overvalued and expensive than Google is, based on both of the companies’ earnings growth expectations and current P/E ratios.  The PEG ratios tell the story, as Google’s is an affordable .88 and Yahoo’s is an expensive 2.12. 

The biggest problem with PEG ratios is the fact that the EPS growth rates are assumptions, and the growth rates might not pan out the way analysts expect them to.  For example, how about if Google doesn’t grow 29% in the next 5 years, but only grows 10% due to some external factors.  Then, the PEG ratio would be totally different, and Google might not be as cheap as it looks. 

Knowing and understanding PEG ratios is crucial for all investors who want to find companies that are undervalued and avoid companies that are overvalued.  Do not judge the P/E ratio on first glance, but instead understand why a P/E ratio is high or low.  Is a company expected to grow at a high rate in the future? And, if so, have investors already factored this expected growth into the stock price? PEG ratios are extremely important, and I hope that you will use them to find great deals on the market. 

 

Niki Pezeshki

College Trillionaire