Understanding the PEG

The PEG helps to forecast a stock

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The price to earnings (P/E) ratio is the most popular way to compare the relative value of stocks based on earnings. It's calculated by taking the current price of the stock and dividing it by the earnings per share (EPS). This calculation tells you whether a stock's price is high or low relative to its earnings, giving you an idea of what value the market places on the company's earnings.

What Does a High P/E Mean? 

Some investors consider that a company with a high P/E is overpriced, and they might be correct.

A high P/E can be a signal that traders have pushed a stock's price beyond the point where any reasonable near-term growth is probable.

On the flip side, a high P/E can also be a strong vote of confidence that the company will continue to have strong growth prospects in the future. This could mean an even higher stock price.

What Is a PEG Ratio? 

Because the market is usually more concerned about the future than the present, it's always looking for some way to project out and forward. The PEG ratio is another ratio you can use to help you look at and calculate future earnings growth. The PEG factors in projected earnings growth rates to the P/E for another number to remember.

You can calculate the PEG by taking the P/E and dividing it by the projected growth in earnings, like this:

PEG = P/E / (projected growth in earnings)

For example, a stock with a P/E of 30 and projected earnings growth next year of 15 percent would have a PEG of 2 because 30 divided by 15 is 2.

The PEG Shows a Relationship 

So what does the "2" mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number, the less you pay for each unit of future earnings growth. So even a stock with a high P/E but a high projected earnings growth might actually be a good value.

Looking at the opposite situation—a low P/E stock with low or no projected earnings growth—you can see that what looks like a value might not work out that way. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.

Two important things to remember about PEG: It's about year-to-year earnings growth, and it relies on projections, which might not always be accurate. By their very nature, projections are not an exact science. 

Articles in This Series 

The PEG ratio is just one component involved in quantifying the value of stocks. A wide range of other factors also plays a part. This is just one article in a series that explains these other factors:
