What is PEG Ratio and How to Find Undervalued Stocks with PEG Ratio?
Today we will talk about a very important ratio that will help you in stock selection. If you have to invest in the stock market, then obviously you will put many good companies on your watchlist, then you will study their best business very well.
You’ve probably even analyzed the business model, balance sheet, profit and loss, and cash flow statements. After some time and hard work, you fall in love with a company. Now you have all the information about this company. But your worries are not over.
Because you are confused about when and at what price you should buy the last company. You must be still confused- Is this the right time to enter? Will there be a margin of safety in this? In short, you are still not confident about the valuation of the stock.
Yes, friend. From the valuation of a stock, we can know when to buy the stock and when to sell it. Valuation is not just a number. You can either use financial models to arrive at a company’s valuation or use ratios to compare them to their peers. Now, whenever we talk about valuation, the P/E ratio immediately comes to our mind, isn’t it? But one such important ratio which we are going to discuss in this article is the PEG ratio.
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What is the PEG Ratio?
What is this PEG ratio? PEG Ratio means Price to Earnings to Growth Ratio. Now we all have heard about Price to Earning i.e., P/E ratio.
The P/E ratio tells us how a stock’s share market price is trading in comparison to its earnings over a period of time. For example, if the P/E ratio of a company is 10, then it means to earn Rs. 1 you need to invest Rs.10. But the biggest drawback of this P/E ratio is that it ignores the future growth rate of the company in the calculation.
Now just think. If Company A is a fast-growing company but has low current earnings, its P/E ratio will be high. This company is expensive according to the P/E ratio. On the other side is Company B, which has high current earnings, but a low growth rate. So, Company B will be considered cheap as per the P/E ratio.
So, if you just look at the P/E ratio, it looks more logical to buy Company B than Company A. But really, you would like to invest in a company that will grow faster in the future, right? To do this, experts use the PEG ratio.
To calculate the PEG ratio, we divide a company’s P/E Ratio by its annual EPS growth. With the PEG ratio, investors can take into account both the company’s current earnings and future growth rates. Generally, as a thumb rule, a company is said to be cheap if the PEG ratio is less than 1. And if it is more than 1, then it is considered expensive. And if the PEG ratio is 1, the company is considered overvalued.
Example of PEG Ratio
For Example, there are 2 companies in the same industry, Company A and Company B. Company A has a P/E ratio of 10 and an earnings growth rate of 10%. So its PEG ratio will be 1.
But if the growth rate is 40%, and the P/E ratio is 30, the PEG ratio would be 0.75. Now imagine if you only pay attention to the P/E ratio, then this company with a P/E of 30 will look expensive to you. But as soon as the growth rate is taken into account, it is realized that a company with a growth rate of 40% is probably cheaper than company B even with a P/E of 30.
That’s why we can call this company undervalued on the scale of relative valuation. Remember, whenever we do relative valuation with the PE ratio or PEG ratio, we always compare them with companies of the same industries.