Must-Know: What Is PEG Ratio and How Is It Used?

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Nov. 20 2020, Updated 1:17 p.m. ET

Stock valuation isn’t straightforward. Investors and analysts generally use a bunch of metrics to determine if a stock is attractive from a valuation perspective. One of the useful measures is the PEG or the price-to-earnings-to-growth ratio. While the name sounds complex, it’s a pretty simple and intuitive way to look at stocks.

The limitation of PE ratio

Before moving on to discuss what a PEG ratio is, let’s first discuss a limitation of the PE ratio. Generally, a stock trading at a lower PE is considered better than its industry peer trading at a higher PE. However, that may not necessarily be always right. That’s because the PE ratio takes into consideration just a company’s current earnings. It does not take into account the rate that a company grows. Let’s look at an example.

There are two companies – Company A and Company B. Company A started operations two years back whereas Company B is 50 years old.

Suppose, Company A’s stock is trading at \$10 and Company B’s stock is trading at \$100. Company A’s EPS is \$0.4 and Company B is \$5. So, Company A has a PE ratio of 25, while that of Company B is 20. So, assuming other factors are the same, is Company B more attractively valued?

To explain this, think about what happens the next year. Company A’s EPS grows to \$0.6. At the same stock price, its PE would fall to 16.7 (that’s the stock’s forward PE). In comparison, Company B’s PE falls to 19. So, Company A’s stock is, in fact, more attractive because of its higher growth.

What is the PEG ratio?

PEG ratio is a stock’s PE ratio divided by its earnings growth rate. In the above example, the PEG ratio shows a better picture of the two stocks’ valuation. Company A’s PEG ratio is 0.5 (calculated as PE/growth rate = 25/50). In comparison, Company B’s ratio is a lot higher at 4.

Many analysts consider a stock to be fairly priced if its PE ratio is equal to its growth rate. That means, its PEG ratio is equal to 1. In the above example, the PEG ratio correctly spots Company A as better-valued, even though the PE ratio doesn’t.

Another point to note is that there are variations in the PEG ratio depending on the growth rate used in the calculation. Some analysts use the expected growth rate for the next year. Others use the average growth rate for the next three or five years.

As with any other valuation metric, the PEG ratio isn’t perfect and shouldn’t be looked at in isolation. Let’s understand the uses, and limitations, of the PEG ratio with some real-world examples.

Applications of PEG ratio: Real-world examples

Just like the PE ratio, the PEG ratio isn’t useful when a company is making losses. That’s one of the limitations of both the ratios. An example of such a company is Tesla (TSLA). Tesla made losses of \$5.72 per share in 2018.

Another limitation of the PEG ratio is that it is meaningless when a company is expected to have a negative growth rate. As an example, Ford (F) reported an EPS of \$0.92 per share for 2018. The company’s expected EPS for 2019 is \$0.5. So, the EPS growth rate is -46%. The PEG ratio here is meaningless. Similarly, General Motors’ (GM) EPS is expected to fall to \$4.78 in 2019 from \$5.53 in 2018.

PEG ratio varies a lot based on the stage of a company’s lifecycle. Generally, the ratio is useful to compare companies in the growth stage. Let’s look at more examples.

Examples of restaurant stocks

Using adjusted TTM (trailing-12-month) EPS, McDonald’s (MCD) PE ratio comes at 25.3. It is useful to use TTM EPS because we already have nine months of 2019 data. Also, 2018 numbers are already a bit old. Using the estimated EPS for the next twelve months, McDonald’s expected growth rate comes at around 5.1%. So, its PEG ratio is approximately 4.9.

Calculating in the same way, Starbucks (SBUX), Chipotle Mexican Grill (CMG), and Yum! Brands (YUM) have PEG ratios of 2.8, 2, and 1.9, respectively.

Looking at the above table, CMG looks pricey based only on its PE ratio. However, its PEG comes close to that of its peers due to its much higher expected earnings growth.

McDonald&#x2019;s PEG ratio

McDonald’s much higher PEG ratio reflects its lower expected growth, even though its PE is lower than that of its peers. Again, it is not fully correct to look at McDonald’s PEG ratio in isolation. There could be many reasons for investors to prefer one stock over the others, despite its seemingly premium valuation based on PEG. In the case of McDonald’s, the company offers an attractive yield of around 2.5%. The stock is a dividend aristocrat, paying dividends for more than 25 years consecutively.

Even with its lower growth, investors expect continuity of its dividends. McDonald’s consistent growth over the years and its global presence make it more valuable for investors, even if the growth is slow. McDonald’s owns lots of real estate as it owns many of its franchise-operated as well as company-operated restaurants. Not only do these generate regular rental income from franchisees, but also lower the costs for the company-operated stores.

Moreover, even though the expected earnings growth is lower, the company’s free cash flow yield (estimated free cash flow divided by market capitalization) is higher than that of the selected peers. This shows that the PEG ratio shouldn’t be looked at in isolation to value stocks.

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