Fundamental analysis and technical analysis are two ways analysts gain a deeper insight into the financial standing of a company. Technical relies on charts and patterns while fundamentals rely on financial statements.
Some of the key metrics used in fundamental analysis are the P/E ratio, ROE, D/E ratio, P/B ratio, CAPE ratio, and Net Profit Margin. Among these, the PEG ratio is a very important metric used to understand the company's growth.
Let’s understand how to use the PEG ratio and its significance:
What is the PEG ratio?
The PEG ratio is a valuation metric that improves upon the P/E (Price-to-Earnings) ratio by using a company's earnings growth rate over a specific period. By factoring in for "growth", the PEG ratio provides a better view of a company's performance and investment potential.
The PEG ratio helps investors and analysts use a stock valuation by balancing its market price with its projected growth.
A PEG ratio of 1 is generally seen as ideal. It shows a balance between the stock’s market value and expected earnings growth.
A ratio above 1, suggests that the stock is overvalued, while a ratio below 1 signals undervaluation which is a buy opportunity.
Here is how you can calculate the PEG ratio:
The first step is to determine the P/E ratio. When calculating the P/E ratio, you’ll need to use the trailing EPS (Earnings Per Share)—this reflects the EPS over the past 12 months or more. The forward P/E ratio is not used in this calculation.
Here’s the formula to determine the trailing P/E ratio:
Trailing P/E Ratio = Current Price Per Share / Trailing EPS (past 12 months)
Once you have the P/E ratio, calculating the PEG ratio becomes straightforward using the formula:
PEG Ratio = P/E / EPS Growth Rate
The combined formula is:
PEG Ratio = (Current Price Per Share / Trailing EPS) / EPS Growth Rate
You can find the required data, such as EPS and growth rate, in a company’s financial statements. Publicly listed companies make these documents readily available to help investors perform fundamental analysis.
Interpretation of PEG Ratio
If Company A has a PEG ratio of 1.5 and Company B has a PEG ratio of 0.90, it indicates that Company A is overvalued, while Company B is undervalued.
A PEG ratio of 1 suggests the stock’s market value aligns with its projected earnings growth and shows equilibrium. A ratio higher than 1 implies that investors may be overestimating the stock's value, whereas a ratio below 1 suggests the stock is undervalued and can prove to be an investment opportunity.
Even if a company seems attractive based on its P/E ratio, it might still be overvalued. Try to factor in the growth rate using the PEG ratio and you will be able to do a better analysis.
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Pros of the PEG Ratio
Let’s understand the advantages and how it benefits investors:
Provides a Comprehensive View: The PEG ratio provides investors with a better perspective of a company’s stock performance. Combining the P/E ratio with earnings growth, helps investors make more informed decisions based on current valuation and prospects.
Identifies Undervalued Stocks: Undervalued stocks are not bad investments. Some hold massive growth potential but remain undiscovered by the market. The PEG ratio helps to compare companies and pinpoint such opportunities. By factoring in these growth projections, it helps you identify hidden gems that can yield higher returns in the future.
Defines Investment Horizons: For stocks with strong growth potential, it can signal a long-term investment opportunity. Whereas, for stocks with limited growth prospects, it can indicate a good time to exit your position.
Provides Quick Stock Screening: The PEG ratio allows investors to filter and screen stocks based on growth potential. It's a tool for narrowing down stocks that align with your investment strategy and avoid those with limited prospects.
Conclusion
The PEG ratio is a comprehensive method for assessing a company's value by factoring in its growth potential. However, as with any financial metric, the PEG ratio should not be used in isolation. Combining it with other financial ratios and analysis methods gives a more proper understanding of an asset’s potential.
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