The PEG Ratio

The Price/Earnings to Growth (or PEG Ratio) is often used as an extension to the commonly used Price/Earnings Ratio when attempting to gauge the attractiveness of a company's valuation using a universal method. The reason why the PEG Ratio has found favour is that it accounts for the pace at which a company is growing its earnings, hence adds earnings momentum, whereas a forward PE ratio by itself is a static figure. The formula is as follows

PEG Ratio =                Price/Earnings Ratio                
                       Forecast Growth Rate in EPS
 
The forecast growth rate in EPS is measured in percent, hence if Company A trades on a 2015 PE Ratio of 15 and is forecast to grow earnings by 25% during that year, it will have a PEG of 15/25 = 0.6.

There are three brackets typically used in conjunction with the PEG Ratio result:
     PEG   <   1      ->  Potentially undervalued. The growth this company offers may be inexpensive given the valuation
     PEG   =   1      ->  Potentially fairly valued with the PE Ratio equal to the forecast EPS growth
     PEG     1      ->  Potentially overvalued. The growth this company offers may be more than factored into the current valuation

An Example

To the right is a table showing four UK-listed clothing retailers. The forecasts for 2016 in terms of the PE ratio and forecast EPS growth are shown with the consensus estimates taken. Simply dividing the PE Ratio by the growth rate in each case produces the PEG figure.

What this example shows is that the company with the lowest PE Ratio may not necessarily be the most 'undervalued' (all limitations of the PEG Ratio not being applicable; to be discussed later). Indeed, the company with the lowest PE Ratio is Bonmarche, trading on a PE ratio of 14.3. However, it has a slower forecast EPS growth rate at 10.94% versus over 22% for Boohoo. Consequently Boohoo actually has a lower PEG, which may be more attractive for investors, especially given the big difference in the two PEG Ratios.

Why does Boohoo have a higher PE Ratio? Investors are factoring in future earnings growing rapidly, now, hence are happy to provide a higher set of valuation metrics for Boohoo on the basis that earnings in a few years' time will justify them.

On the other hand ASOS has a PE Ratio over 3 times that of Next, at 50.73, yet has a lower PEG by about 10%. That is the result of investors expecting ASOS to deliver impressive ~31% earnings growth in the year to 2016. A step further to the above table would see you produce an adjusted-PE Ratio by stripping out any surplus net cash or adding back any net debt. That would account for any of the companies having a significant cash/debt balance.

However, the PEG Ratio has several limitations...

Although the PEG ratio is useful when comparing companies that are very similar in their operational business and sector of operation, there are some very major limitations that the PEG Ratio has that can actually obscure whether a company is good value or not. That is unless you are able to see through them. A selection of the most important points to watch out for are shown below:

1. Are the forecast EPS growth figures realistic?
In many cases it's the fundamental aspect of whether forecasts will be met that leads to a company with a low PEG being transformed overnight into a company with a high PEG if forecasts are cut.

For example, Mysale Group (LSE:MYSL) was trading on a very high PE Ratio although supposedly boasted excellent EPS growth moving forward. A trading update cut those hopes of rapid EPS growth short, and the result was that Mysale was left looking distinctly overvalued. The share price halved.

2. Is the EPS growth sustainable?
In turnaround situations where profits may have been heavily depressed, a sudden upturn in EPS growth as a result of cost-cutting or other one-off events would lead to a misleading PEG Ratio being derived.

As an example, say that Company A was on a PEG Ratio of 1.0 but in 2015 would experience 50% EPS growth as a result of cost-cutting. In every year thereafter EPS growth is just 4%. To use a PEG Ratio reliably, earnings growth should not only be realistic but they should be sustainable going forward and not one-off events.

3. The PEG Ratio with Negative/Flat Earnings
Through the formula, it is not possible to apply the PEG Ratio method to companies that are experiencing negative earnings as a negative PEG Ratio would result. However, the metric is not particularly useful for companies with flat earnings or low earnings growth either. For example, if Company A is on a PE ratio of 12 and is growing earnings at 3% per annum, that would give Company A a PEG Ratio of 4. That makes the company fall well into the overvalued bracket.

However, a PE ratio of 12 in absolute terms is not high (assuming good earnings quality) and 3% growth for a large-cap is respectable. Hence to look at the PEG Ratio in isolation can give a misleading result. After all, a company on a PE Ratio of 10, PEG Ratio of 4 but that has a sustainable 8% dividend yield may be attractive solely as a result of the dividend.

What is the PEG Ratio useful for?

Given the seriousness of those three limitations alone, it is important, as with many metrics, to not look at the PEG ratio as a sole indicator of a company's attractiveness. Combining a range of metrics such as PE ratios, free-cash flow yield and other metrics help to provide a far more rounded view of a company.

What the PEG ratio is useful for is operationally similar companies that are growing rapidly, where growth rates are a key differentiator.