Question

In: Finance

The Peg Ratio appears to be a refinement that allows us to do what? Is the...

The Peg Ratio appears to be a refinement that allows us to do what?

Is the ratio aptly named? Explain and discuss...

Expert Solution

a. One of the most common used measure of valuing stocks of a company is it's Price to Earnings or PE Ratio.However, the P/E ratio may not always be useful for analyzing companies as they do not take into account the growth rate of the company.

PEG ratio or Price to Earnings Growth Ratio overcomes this limitation by combining the Price to Earnings or PE Ratio with that of the expected growth of a company's earnings .

PEG ratio helps in reaching at a better valuation for companies in the growth stage.

Formula for Calculating PEG Ratio:

PEG Ratio= P/E Ratio/Earnings Growth Rate

Generally, we consider a value of PEG ratio of less than 1 , then the stock is undervalued(cheaper) and any value greater than 1 is considered to be overvalued(more expensive).

Different industries will have different average values of PEG .The value of a company PEG ratio should be compared with the PEG ratios of other similar companies as well as the industry(in which the company is operating) average PEG ratio to arrive at a better valuation

Example:

Suppose there are two companies:A & B.A has PE Ratio of 20 and B has PE ratio of 24.A's earnings is expected to grow at 8% per year for the next eight years and B's earnings is expected to grow at 12 % per year for the next eight years.

Let us now calculate the PEG ratio for both A and B

Using the values given in the question and the formula for PEG Ratio(as discussed above) we get:

PEG Ratio for A= 20/8 ie. 2.50

PEG Ratio for B= 24/12 ie. 2.00

Thus, we can see from above that even though company B has a higher P/E valuation , it is in reality cheaper when we consider growth as compared to company A.

If here instead of comparing PEG ratio we would have compared only the P/E ratio then company A would have been a better investment as it had a lower PE ratio of 20 which would have been wrong.

Thus PEG ratio helps in better valuation.

However, PEG ratio should only be used for fast growing companies or companies in the beginning part of the growth stage.It should not be used for slow growing companies or value stocks.

b. PEG ratio is apltly named as it combines the PRice to Earnings ratio with the expected growth of a company's earnings.

jeff jeffy answered 6 months ago

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