Most companies change with time. Some grow to be bigger companies than they were a year ago. Some grow at slower pace. Another metric is needed to compare PE of companies with different growth rates. This metric is call PEG which stands for PE/Growth rate ratio. It divides the PE by the annual income grow rate expressed as a percentage. It answers how much PE is there per unit of growth. Companies might have same PE but the growth may be vastly different. The PEG ratio takes the growth rate of a company into consideration. A company growing faster than another company is worth more if all else being the same. As time goes on, the faster company will generate more income. The faster growing company will have a smaller PEG to reflect its growth strength.
Let’s look at two companies.
Company 1:
PE 10
Last year earnings: $10/share
This year earnings: $15/share
Growth = (15 -10)/10 = 5/10 = 1/2 = .5 = 50%
The PEG of Company 1 is 10/50 = 1/5 = 0.2
Company 2
PE 10
Last years earnings: $1.00
This years earnings: $1.10
Growth = (1.1 – 1.0)/1.0 = 0.1/1.0 = .1 = 10%
Company 2’s PEG is = 10/10 = 1.0
A PEG of 1 is obtained when grow rate matches the PE and indicates a company is fairly priced. A PEG lower than 1 may be a good value. A PEG higher than 1 may indicate over valued.