What is the PEG ratio? Description
The P/E ratio is a common measure of relative value of equities based on
their earnings per share (TTM). Equities with a high
P/E ratio suggest a market consensus that
the firm has strong future earnings growth prospects. Because the P/E ratio
does not reflect future earnings growth, we use the PEG ratio to determine
whether the market valuation is supported by the predicted future earnings
growth rates.
Origin of the PEG ratio. History
The PEG ratio was developed to address shortcomings in the use of the P/E
ratio. Specifically, it was created to adjust the P/E ratio for relative projected
future earnings growth rates of different firms.
Calculation of the PEG ratio. Formula
PEG ratio = (Market Price / Earnings
Per Share) / (Predicted Annual Growth in Earnings)
Usage of the PEG ratio. Applications
 Portfolio managers and analysts commonly compare PEG ratios to identify
undervalued and overvalued equities.
 A common application is applied to emerging market equities (where earnings
growth rates are high and uncertain). As a general rule of thumb, when the
PEG ratio is approaching a value of 1.0, the firm's equity is considered
"fairly" valued. If the PEG ratio is less than 1.0, the equities are considered
"undervalued". If the PEG ratio is greater than 1.0, the equities are considered
"overvalued".
 Since the market tends to price equities relative to their sector, a
meaningful comparison of PEG ratios (and P/E ratios) demands viewing them
against the sector or industry average.
Steps in the PEG ratio. Process
 Determine the firm's current market price per share (price of equities).
 Determine the firm's most recent published Earnings per Share (trailing
twelve months).
 Determine the firm's expected growth in Earnings per Share (use the
longest, reliable estimate available, preferably 2+ years).
Strengths of the PEG ratio. Benefits
 The PEG ratio provides a simple and reliable valuation "rule of thumb".
If fully and fairly valued, a growth equity should present a P/E ratio equal
to the percentage growth rate of the Earnings
Per Share (EPS) of the firm.
Limitations of the PEG ratio. Disadvantages
 High risk companies trade at lower PEG ratios than low risk companies
with comparable growth rates.
 High growth firms trade at lower PEG ratios compared to average (or
low) growth firms.
 Firms investing less in high quality projects and with high reinvestment
rates demonstrate higher PEG ratios.
 The PEG ratio is sensitive for the interest rate. A decrease (increase)
of the interest rates is resulting in fewer (more) equities appearing to
be undervalued.
 While the firm matures, the PEG ratio will be affected by the firm's
changing risk, dividend and reinvestment profile.
 The PEG ratio of comparable firms will be affected by the composition
of the firm (i.e., business mix, risk and growth profiles).
 Firm's paying significant dividends require a derivative of the PEG
ratio, the PEGY ratio = PE / (Projected Annual Earnings Growth +
Dividend Yield).
 In industries where equities are valued on factors other than earnings
(e.g., assetbased firms), the P/E ratio is not accurate in reflecting growth
rates.
 Finally, intrinsically, there is no fundamental basis for concluding
that a firm's equities are undervalued or overvalued, based solely on the
PEG ratio.
Assumptions of the PEG ratio. Conditions
 The PEG ratio assumes the P/E ratio and earnings growth rate reflect
a consistent base year and forecast period.
Book: Damodaran,
Aswath  Investment Valuation: Tools and Techniques 

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