Price-to-earnings, or P/E ratio, as it is commonly known. It is probably the most recognizable metric used to value stocks. Are they the most useful? Well, for one, they don’t take into account any growth of the company, and no one metric is useful all by itself. They need to be used with other metrics. The PEG ratio combines all benefits of value investing, plus adding in the growth component as well.
The PEG ratio was originally developed by Mario Farina, who wrote about the ratio in his book “A Beginners Guide to Successful Investing in the Stock Market,” published in 1969.
Peter Lynch, the famous investor, later popularized it in his book “One Up on Wall Street,” published in 1989. He wrote in the book:
“The P/E ratio of any company that’s fairly priced will equal its growth rate.”
For those of you not familiar with Lynch, he was the fund manager for the Fidelity Magellan Fund, which he took over when he was 33 years old and ran for 13 years. His record of 29.2% annualized returns during the 13 years more than doubled the S&P 500 during the same period.
Lynch used the PEG ratio as a way to determine the fair value of stocks and screen for undervalued companies.
OK, let’s dive in and take a deeper look at the PEG ratio.
What is the PEG Ratio?
“The price/earnings to growth ratio (PEG ratio) is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period.
The PEG ratio is used to determine a stock’s value while also factoring in the company’s expected earnings growth and is thought to provide a more complete picture than the P/E ratio.”
The PEG ratio is easy to calculate and gives you a quick snapshot of the value and growth of a company. The ratio can also tell if the company is undervalued compared to its earnings growth.
Let’s take a look at how to calculate the ratio.
How Do You Calculate the PEG Ratio?
The formula for the PEG Ratio is:
PEG Ratio = (Price / EPS) / EPS Growth
(Where EPS equals earnings per share)
To calculate the PEG ratio, we are going to need some numbers that we can gather from the annual or quarterly reports. You can cheat and pull the numbers from your favorite financial website if you choose, but I like to go straight to the source, as it keeps things consistent.
Let’s break this down a little bit more.
The formula is the P/E ratio divided by the EPS or earnings per share growth.
The first part of the formula is calculating the PE ratio for our company. Again there are two ways to do this. First is to look up the PE ratio from your favorite website, or to use the numbers from the latest financial reports.
To calculate a price to earnings ratio, we need the current price and the earnings for the company.
Next, we need to find the growth rate of the earnings; again, we can use the info from a financial website, looking for the analyst’s estimate of growth for the next five years. Or we can use the information from the financial reports and look at the historical growth of earnings and use that for our basis.
I like to use the historical growth rates as a measure, as opposed to future growth rates from analysts, no offense to the analysts, but I think basing the future growth rate on what the company has already done makes more sense to me.
To calculate the earnings growth, you can either look at the earnings reported on the income statement, or you can use the EBITDA earnings for the company for the last five years.
We calculate the EBITDA earnings by taking the operating earnings from the income statement and adding back the depreciation and amortization from the cash flow statement. A little more work, but I feel a little more accurate reading, and not that much more work.
And once we have the EBITDA earnings for the last five years, then we need to find the CAGR rate of these earnings. CAGR means finding the combined average growth rate over five years. For the CAGR calculations, I use a calculator from Investopedia, or you can calculate your own from Excel.
OK, let’s look at our first company.
For our first example, I thought we could analyze Universal Forest Products (UFPI). Universal Forest has a current market cap of $2.3B, and the company deals with wood, duh.
The numbers we need to gather to calculate our PEG ratio:
- Current market price
- Earnings per share
- The EBITDA growth rate for five years
First, let’s find the current market price for UFPI by looking it up on Seeking Alpha.
OK, that was easy, now let’s look at the earnings.
So our earnings per share for UFPI is $2.91 a share for the year ending 2019. You could do the same for a company using their quarterly reports or 10-Q.
Next, we will calculate the EBITDA for Universal Forest by looking at the income statements for the last six years, as well as the cash flow statements for the same period. We are using six years because we need five years of growth, and the first year doesn’t count as a growth number, rather as a starting point.
First, I will pull up the income statements and find the earnings from operations for all six years. To do this, I will look at the most current annual report and then go back three years and pull up that annual report, each income statement and cash flow statement is listed for three years on the annual reports.
As you can see, I used the 10-k from 2019 and the 10-k from 2016 to get six years’ worth of data.
Now I will do the same for the cash flow statements to find the depreciation and amortization for all six years.
Now we can pull those numbers and find our EBITDA earnings for our PEG ratio.
Now that we have calculated our EBITDA, we can find the growth rate of the earnings for the last five years. Like I mentioned earlier, I like to use the calculator from Investopedia. But you can create a CAGR growth rate calculation on Excel, but I am not the excel wizard that Andrew and Andy are so I will use the one from Investopedia.
Here we go:
Notice that we enter our first number from the chart for EBITDA from 2014 of 133690 as our beginning value and the ending value of 311725 from the same chart. The reason I put five periods is we are looking at the change in values from 2014 to 2019, which encompasses five years.
And once we hit the calculate button, we get our result.
Now that we have our growth rate for the EBITDA, we can go ahead and calculate the PEG ratio for Universal Forest Products.
PEG Ratio = ( Current Price / EPS ) / Growth of EBITDA
- Current Price = $33.99
- Earnings Per Share = $2.91
- Growth Rate of EBITDA = 18.45
Let’s plug the numbers into our formula.
PEG Ratio = ( $33.99 / $2.91 ) / 18.45
PEG Ratio = 11.68 / 18.45
PEG Ratio = 0.63
Now, wasn’t that fun and pretty darn easy too. For the results, we will discuss some more in the next section.
I would like to look at a few more to make sure we have the concept down.
Remember, we are looking for undervalued companies with good growth as investments, that is the sweet spot.
Let’s take a stab at Disney, with the rocky stock market of late the price of Disney has fallen dramatically over the last couple of weeks.
Currently, the market price for Disney is:
And their earnings per share from the latest 10-k 2019 was $6.64.
Next, I will put together a chart listing the EBITDA from Disney’s latest 10-k.
Going back to our calculator, we find our growth rate for the EBITDA.
The growth rate for Disney for EBITDA over the five years is 4.49%.
Now that we have all components for Disney, let’s calculate the PEG ratio.
PEG Ratio = ( Current Price / EPS ) / Growth Rate of EBITDA
PEG Ratio = ( $94.92 / $6.64 ) / 4.49
PEG Ratio = 14.29 / 4.49
PEG Ratio = 3.18
OK, that was pretty easy, why don’t we try one more to make sure we have the hang of this.
Let’s do Visa and see what our results will be. For Visa, I am going to do an abbreviated version.
The current market price for Visa is $161.12, and Visa’s EPS as of the most current 10-k for 2019 is $5.32.
The range of EBITDA for Visa from 2014 to 2019
- 2014 = $8,159
- 2019 = $15,737
The growth rate for the five years is 14.04%.
Now that we have our numbers let’s plugin everything to our formula.
PEG Ratio = ( $161.12 / $5.32 ) / 14.04
PEG Ratio = 30.29 / 14.04
PEG Ratio = 2.15
Now that we have done a few, I think we have the hang of how to calculate a PEG ratio for any company we are interested in buying or selling.
Let’s take a look at interpreting the results of our calculations.
What Is A Good PEG Ratio?
As with the PE ratio, a lower PEG ratio is better. The standard answer is that we are looking for a number below one for the best results. A result lower than one may indicate that the company s undervalued.
And likewise, any calculations using estimated numbers are going to be suspect. That is why I like to use historical numbers; they are based on events that have occurred, we can argue about whether my assumptions about Disney, for example, will continue to grow their earnings at 4.49% over the next five years.
But if you base your projections on forward-looking numbers, these are strictly a guess or forecasting, and no one knows the future.
If you use the PEG ratio from a published site, it is important that you determine the growth rate that is used in the calculation. For example, gurufocus.com uses the PE ratio based on the current-year numbers and a five-year growth rate of EBITDA.
We can calculate the PEG ratio based on one-year, three-year, and five-year growth rates, and the formula is only as good as the numbers we use for our calculations. Garbage in, garbage out.
The degree that the PEG ratio can tell us whether a company is undervalued or not depends to some degree on the industry and company type.
Peter Lynch was a firm believer that the PE ratio and the growth rate of the earnings should be equal, which would indicate a fairly valued company. When a company expands beyond a ratio of one, then it is considered overvalued.
If we take our results from the above test cases:
- Universal Forest Products – 0.63
- Disney – 3.18
- Visa – 2.15
What does that all tell us? At first blush, it would appear that Universal Forest is the most undervalued of the bunch. And that Disney is the most overvalued of the group.
The apparent overvaluation of Disney could be that the market expects more growth than our estimates predict, or more likely that increased demand for the stock has driven the price higher.
Less than one could indicate that are estimates for growth are too low for the company or that the market is underestimating the company’s growth and value.
A PEG ratio can be negative; such as when a company’s Net Income, such as Tesla, is negative. There is also the possibility that the future earnings may turn negative such as many companies will probably experience in the upcoming quarters as the economic fallout from the Coronavirus pandemic come to light.
PEG ratios that are negative are considered worthless and should be considered companies with high risk.
One of the criticisms of the ratio is that it fails to properly take into account the relationship of the PE ratio and growth because it fails to factor in the return on equity.
Another criticism is the varied use of different growth numbers, either from the length of samples, or from net earnings, or EBITDA. There is no current standardization of the formula, which can lead to many different options for calculating the ratio.
One big disadvantage to the ratio is it is less effective for measuring companies without high growth. Large, well-established companies like Johnson & Johnson, a perennial dividend aristocrat offers a great dividend, but little in the way of growth.
PEG Ratio by Industry
According to the research by Professor Damodaran, the overall PEG ratio for the market is currently 1.78. From his website, I will show a smattering of a few industries so we can see how they compare to our test companies.
- Banks – 1.45
- Biotech – 3.08
- Oil/Gas – 0.90
- Healthcare Products – 2.26
- Software – 1.44
Note that one of the industries getting savaged in the market right now is the airline industry, and all of those companies have a PEG ratio of 0.79, which indicates the undervaluation of the industry as a whole.
As value investors, we are always looking for a deal, but beware of value traps, and in an environment like today with so much volatility, it pays to do your research and make sure you understand the whole picture and not just rely on one variable.
Andrew has done some research for me that I will include for you to be able to download, showing the results of a 20-year backtest on the PEG ratios of every company in the S&P 500, in addition to the performance results of these companies compared to their PEG ratios.
In other words, if the company has a low PEG ratio, the chart shows how the company performed over that period.
The current PEG ratio for the S&P 500 sits at 1.8, which is an all-time high, although the ratio has only been tracked since 1986.
If you are the type that would like to screen by this ratio as you investigate companies.
Here is a list of some of the better sites that allow you to sort by the PEG ratio:
Any of the above screeners can help you find great companies that currently have a PEG ratio below one, or a company close to one. A great place to start your analysis of the company.
The PEG ratio is a great starting point to find undervalued companies that are exhibiting growth in their earnings. I like to use EBITDA as my earnings numerator because, in part, it is harder to manipulate with share buybacks.
As you become more comfortable analyzing companies, you will discover some companies that may have flat earnings but because the company is continually buying back shares and reducing the share count, which in turn will elevate the earnings per share.
The PEG ratio is another tool we can add to our toolbox when examining a company, and it is fairly easy to calculate and gives a quick look at the possibility of being undervalued by the market, with a growth aspect to boot.
My thought is, if it was good enough for an investor as skilled as Peter Lynch, then it is good enough for me.
I would encourage you to download the spreadsheet that Andrew created outlining the PEG ratios for each company in the S&P 500 over the last 20 years. Not only is it a great resource to see how your favorite companies have done over the years, but it is also a great resource to see the impact that a low or high PEG ratio can have on the returns of your company.
As always, thank you for taking the time to read this article.
I hope you find something of value that you can use on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out and I will help in any way that I can.
Take care and stay safe,