Fundamental analysis is a technique for determining the actual value of a stock based on both internal and external factors. Although it may seem difficult to evaluate, there are many ratios and methods for a basic analysis that might help. PEG ratio is one such instrument.
The Price/earnings to growth ratio or PEG ratio enables you to estimate the value of a stock while also taking the company's earnings growth into account. This ratio provides a more comprehensive understanding of a stock's prospects than the P/E alone because by enabling an investor to estimate the growth rate of a firm. All other factors being equal, a firm with a high probability of revenue, profits, and cash flow growth is more valuable than one with a low probability of growth.
The PEG ratio is calculated by dividing a company's price-to-earnings ratio by its average annual earnings growth rate. By accounting for the predicted future growth rate in profits per share, this ratio modifies the conventional P/E ratio. Companies with a strong growth rate and a high price to earnings ratio may benefit from this "adjustment."
Evaluation of PEG ratio
A PEG ratio of 1 indicates equilibrium, according to renowned financial and value investor Peter Lynch. This balance exists between the estimated stock value and the stock's earning potential.
PEG ratios above and below 1 indicate that the market has miscalculated the value of that stock. If a stock's PEG ratio is more than 1, the market has overvalued it compared to its earnings potential. If a stock's PEG ratio is less than 1, it indicates that the market has undervalued it in relation to its expected earnings potential.
Drawbacks of PEG ratio
Although the ratio helps to account for growth over time, it usually only considers a limited time period, such as one to three years. As a result, one or two years of rapid growth could exaggerate the advantages of purchasing the faster-growing firm.
Free Cash Flow, which determines a company's worth in the end, as well as EPS growth can not translate into an increase in cash flow. Though PEG is frequently a beneficial adjustment to P/E, it should simply be one of many aspects to be taken into account when evaluating a firm.
READ MORE: What is total expense ratio (TER)? Everything you want to know
Summing Up
Any single financial statistic, including the PEG ratio, should not be relied upon primarily by investors. Furthermore, a corporation is neither a good investment nor a poor one simply because its PEG ratio is less than or larger than 1.0.
When comparing similar businesses in terms of their respective growth, the PEG ratio might be useful. However, one should consider the PEG Ratio as one of many criteria in analysing any investments given the estimations that go into it and the uncertainty of any company's future development.
