To keep our body nutritious, it is important to give protein, minerals, and vitamins in a proportionate manner. If apples are good for health, you cannot keep eating apples your whole life as there have to be other nutritious elements that need to be added to be healthy.
To have a healthy portfolio, you need to evaluate a company, not by just using the PE ratio, as it determines its valuation. The company's growth potential is equally important, which can be determined using the PEG ratio.
Let’s dive deeper into it-
What is the PEG ratio?
The PEG ratio, or the price/earnings to growth ratio, is a valuation metric used to determine the relative value of a stock based on its price-to-earnings (PE) ratio and its expected earnings growth rate.It is calculated by dividing a company's PE ratio by its earnings growth rate. The result indicates how much an investor is paying for the expected future growth of the company relative to its current earnings.
When you talk about its implementation, it states that 1 indicates that a stock is fairly valued, while a PEG ratio of less than 1 indicates that a stock may be undervalued, and a PEG ratio of more than 1 indicates that a stock may be overvalued.
For example, if a company has a PE ratio of 20 and an expected earnings growth rate of 10%, its PEG ratio would be 2 (20/10). This means that the investor is paying twice the company's earnings growth rate for the stock, which may suggest that the stock is overvalued.
How is PEG ratio different from PE ratio?
There are only two difference lies between PEG and PE ratios; these are as follows-
Formula - The PE ratio is calculated by dividing a company's current stock price by its earnings per share (EPS), remember the PEG ratio is calculated by using the PE ratio only.
Approach: The most important difference between these two is the approach when the PE ratio indicates only the historical aspects of the company; at the same time, the PEG ratio will help you in determining both historical aspects and future growth of the company.
Valuation: The PE ratio is primarily used to determine whether a stock is undervalued or overvalued based on its current earnings, while the PEG ratio is used to compare stocks with different growth rates and decide which is a better value.
Comparison: The PE ratio can be used to compare companies within the same industry, but the PEG ratio is advantageous when comparing companies with different growth rates or in different industries.
Limitations: While the PE and PEG ratios can provide valuable information, both should not be used in isolation and must be interpreted in the context of other financial metrics, such as the company's debt levels, cash flow, and industry trends. Additionally, the PEG ratio can be less reliable if earnings growth rates are difficult to predict or if the company has a high debt load that could limit its ability to grow.
It could be a useful tool for you as it takes into account both the company's current earnings and its expected growth rate, providing a more comprehensive picture of a company's value. However, it is important to note that the PEG ratio should not be used in isolation and should be considered alongside other valuation metrics and fundamental analysis.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com
Disclaimer: This story is for informational purposes only. Please speak to a SEBI-registered investment advisor before making any investment-related decision.