PROJECTED EARNING GROWTH

The projected earning growth, price/earnings to growth, or PEG ratio is a way of measuring the way the P/E relates to annual growth in a company. It is determined by taking the P/E of a company and dividing it by the annual EPS growth. Since the EPS growth rate is necessarily a prediction, a PEG is not an entirely accurate measurement, but it can nonetheless provide an important insight into the valuation of a company’s stock. When determining a PEG, it is generally preferable to use a larger P/E average, such as a ten-year, or P/E10. This normalizes the number somewhat, cancelling out some of the noise that can interfere.

For example, if a company had a EPS average over the previous ten years of $64, and a stock price of $16, it’s P/E10 is 4. If the growth rate is 2%, then the PEG is 2. If, on the other hand, the growth rate is 8%, the PEG is 0.5. Because the PEG essentially measures how well the company’s share price is keeping up with its overall growth, it is an excellent tool to determine whether a stock is overvalued or undervalued.

As a general rule of thumb, the lower a stock’s PEG, the more undervalued it is. A stock with a PEG of less than 1 has plenty of room for growth in the future, and is an excellent investment. In some cases the PEG may be much lower, and often PEG is low across the market after a large sell-off since company assessments of their growth potential ramp up before the markets have a chance to value them appropriately. Generally, investors stay away from stocks with PEGs of higher than 2. Of course, in some cases there may be other strong fundamentals that mitigate the high PEG, such as a surge in demand that has not yet been absorbed into EPS growth predictions.