While investing for a longer period of time, making decisions on the basis of a single financial matrix could be harmful to the financial objective for which you might be investing.
PE ratio might be the most important and common matrix to use among investors, but what if there is some other matrix or you can say advanced matrix you can use to give a strong base to your investment decision?
Let’s walk through the concept of PEG or profit earning to growth ratio and compare it with the price earning ratio.
What is the PEG ratio?
The PEG ratio (price/earnings to growth ratio) is a financial metric that is used to determine the relative value of a stock. It is calculated by dividing the price-to-earnings (P/E) ratio of a stock by the company's projected earnings growth rate. The PEG ratio provides a more complete picture of a stock's value by taking into account its projected earnings growth.
How is it different from the price earning ratio
Here are the five ways PEG ratio has an advantage over PE ratio
PEG ratio evaluates growth
The PE ratio measures the price of a stock relative to its earnings, while the PEG ratio takes into account the company's growth rate. It means that a company with a high growth rate and a high PE ratio may still be undervalued based on its growth potential. The PEG ratio helps you to account for the company's future growth potential and gives a more complete picture of the stock's valuation.
Comprehensive measure of the company
While the PE ratio provides a quick snapshot of a stock's valuation, the PEG ratio provides a more comprehensive measure by taking into account both the company's earnings and growth rate. It can help you to make more informed investment decisions and avoid stocks that may be overvalued based on PE ratio.
Helps in value investing
A PEG ratio of less than 1 is generally considered to be a sign that a stock is undervalued. It means that the stock's price is not fully reflecting the company's growth potential. By using the PEG ratio, you can identify undervalued stocks that may have been overlooked based on the company's PE ratio alone.
Complete comparison of stocks
Because the PEG ratio takes into account the company's growth rate, it is a more reliable measure for comparing stocks in different industries. It is because different industries may have different growth rates and therefore different PE ratios. By using the PEG ratio, you can compare stocks in different industries on a more equal footing.
Risk reduction
By taking into account the company's growth rate, the PEG ratio can help you to reduce your risk exposure. It is because stocks with a high growth rate are more likely to continue growing in the future, reducing the risk of the stock losing value. By using the PEG ratio, you can identify stocks that have a good balance of growth potential and valuation, reducing your risk exposure.
Conclusion
While the PE ratio is a useful tool for evaluating a stock's value, the PEG ratio can provide investors with a more comprehensive measure of valuation. By taking into account the company's growth rate, the PEG ratio helps you to identify undervalued stocks, compare stocks in different industries, and reduce their risk exposure.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com
