PEG Ratio Calculation
In order to make reliable comparisons between the values of various stocks it is recommendable to use the price to earnings (P/E) ratio. The latter is calculated by dividing the current price of the stock by the earnings per share (EPS). As a result you gain an idea about the value of the stock's price relative to its earnings.
In some cases a too high P/E may indicate an overpriced stock. Additionally, it may also mean that traders have artificially inflated the price of the stock, which may result in an inability for further near term growth.
On the other hand, a high P/E may have positive meanings. For instance, it may indicate to investors that the company has a great potential for growth. This may further lead to the increase in the stock price.
A major characteristic of the stock market is that it is directed toward the future performance and projections.
PEG Ratio Calculation
Aside from the P/E for measuring the future earnings growth is the PEG ratio. The PEG calculations are based on P/E. So, the formula for calculating the PEG is:
PEG = P/E / Projected Growth in Earnings
Example: Company XYZ has a P/E equal to 40. The projected earning growth for the next year is 10%. So the PEG for company XYZ is 4, which is derived from dividing 40 by 10%.
So, how we interpret this result? Generally, a lower result signifies the fact that you will pay less for each unit of earnings growth that is generated in the future by the stock. On the other hand, a stock that enjoys both high P/E and projected earning growth may represent a good value stock. However, you should keep in mind that PEG being a ratio represents a relationship between two factors.
An expensive investment may be the one which has low P/E value and no projected earning growth. In such a case you should carefully evaluate all other factors to see whether the stock is worth the headache.
Final Piece of Advice
You should keep in mind that the PEG is calculated on the basis of projections about the future which in many cases may not clearly depict the reality. Additionally, the PEG is about year-to-year earnings growth.
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