Price to Earnings Growth Ratio (PEG) Explanation
High growth rates are one of the factors that greatly attract investors to a particular stock. As a result of the increased attention, the price of the stock may hit the skies. However, this doesn't indicate an overvaluation of the stock, because if a company is experiencing higher than the average growth it deserves the attention and the subsequent higher prices.
A ratio that manages to explain this attention is the price/earnings growth ratio (PEG). In order to calculate it you should divide the P/E by the projected earnings growth rate. If the value of the PEG is above 1, you should approach this stock with caution, because this higher value may indicate a company that trades above its growth rate allows. The value you should look for is 1 or below it.
When you compare the P/Es of different companies you may notice that the P/E of one is greater than the other. One company may appear far more expensive than the other operating in the same industry. However, if you make a closer examination and see that the one company is expected to grow more than the other, you will definitely have to choose the first.
So, when you make your analysis of a stock, you look for a forward P/E in the PEG. However, a low PEG should be searched for if a trailing P/E is applied. You should also look for a PEG that has an amount of 1 or less.
However, you should keep in mind that there are differences in the industries in which companies operate. You should not forget that a comparison between companies of the same industry should be done.
Another word of caution concerns large cap companies for which PEG is applied with a lower success. This is caused by the fact that such companies due to their size grow much slowly.
PEG has its disadvantages. One of them is its heavy reliance on earnings estimates. This is considered drawback since estimates are characterized with uncertainty until the actual numbers are reported. Since projections may not be the same as the actual numbers at the end of the year, the PEG may have totally wrong results.
Thus, you should include a margin for error. 15% is a good margin you can consider.
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