PEG ratio along with PE ratio are two most important ratios for the value investors.PEG ratio provides complete picture of the share to the stock market investors.It must be used by the stock traders in the stock valuation and stock market analysis.PEG ratio is mostly used in the fundamental analysis of the overall stock market.
PEG ratio is calculated by dividing the PE ratio by expected earnings of the stock in next few years.It can be calculated by the following formula:
PEG ratio = PE ratio/Expected earnings growth rate
The expected earnings growth rate can be estimated by using different websites and tools.The five year growth estimates provided by websites like Yahoo ! finance is a very good source to get data on expected earnings growth rate.Most of the stock investors desire PEG ratio between 0 and 1.The stock having PEG ratio more than 1 is considered overvalued and less than 1 is considered undervalued.But it depends upon the industry and business type.The standard PEG ratio varies from industry to industry.
According to the analysis conducted by renowned financial company Motley fool,stocks with the low PEG ratios outperform companies with high PEG ratio.Motley fool conducted the analysis from year 2003 to 2006.The stocks with PEG ratio between 0 and 1 performed best in last three years.Following are the results of the analysis conducted by the Motley fool.This analysis was done on the stocks of 1000 companies. This analysis is a very good proof of the advantages offered by the PEG ratio for the investors.
PEG ratio is mostly preferred over the PE by the value investors all over the world.They believe that PEG ratio gives more complete as compared to the PE ratio.It is preferred because it also includes the future growth potential rate of the given company while valuing the stock.Still some stock market experts believe that PEG fails to address most important questions asked by the value investors.
Some stock market experts point out that PEG ratio has some disadvantages or limitations.The most important limitation of the PEG ratio is that it ignores important metric such as cash flow,revenue growth,debt and dividends.Market analysts believe that PEG ratio should be interpreted properly to get a clear idea about the stock.It should be better applied to stocks having low dividends payments rates.As PEG ratio doesn’t include the dividends in its calculation formula.So this means that it is a very good valuation metric for value investors but not for the income investors. As income investors are mostly focused on selecting stock with good dividend income. Income investors can use ratios like dividend payout ratio,dividend yield ratio and free cash flow ratio.These ratios are usually very helpful for income investors.
The results produced by PEG ratio are unreliable when slow growing companies are compared with fat growing companies.They are also not reliable when low PE ratio companies are compared with high PE ratio companies. Value investors should compare single stock PEG ratio with the overall industry average PEG ratio.This will help them to devise more reliable investing strategy in the stock market.