When you are exploring stocks to invest in, the price alone doesn’t tell the full story. Two companies might have similar prices, but very different futures. That’s where the PEG Ratio comes into play. PEG stands for Price/Earnings to Growth Ratio, a smart way to look beyond the usual price-to-earnings (P/E) ratio by adding in the company’s expected earnings growth. 

This article explains what the PEG ratio is, how to calculate it, and why it matters for anyone investing in India’s stock market. Let’s start!

What is the PEG Ratio?

The PEG ratio combines a company’s Price-to-Earnings (P/E) ratio with its Earnings Per Share (EPS) growth rate. It shows whether a stock is undervalued or overvalued by linking its current price to its future earnings potential. While the classic P/E ratio only considers price versus current earnings, the PEG ratio also takes into account how quickly earnings are expected to grow. This makes it a more forward-looking and useful indicator for investors.

PEG Ratio Formula

Here’s the formula you can use to calculate the PEG ratio:

PEG Ratio = Price-to-Earnings (P/E) Ratio/EPS Growth Rate

Where:

  • P/E Ratio = Market price per share ÷ Earnings per share (EPS)
  • The EPS Growth Rate is usually expressed as a percentage and is the expected or historical annual growth of earnings.

Let’s say Company ABC shares are priced at ₹200 with an EPS of ₹10. Its P/E ratio would be:

₹200/₹10 = 20

Now, if the company’s expected annual EPS growth rate is 15%, the PEG ratio is:

20/15 = 1.33

This means investors are paying a premium relative to the company’s earnings growth, which might suggest it is slightly overvalued if the PEG is significantly above 1.

Interpreting the PEG Ratio

  • PEG = 1: Stock is fairly valued. Price reflects earnings growth fairly.
  • PEG < 1: Stock may be undervalued. The price is low relative to the earnings growth potential, often indicating a buying opportunity.
  • PEG > 1: Stock could be overvalued. The price is high compared to earnings growth potential, which could be risky.

Keep in mind that this interpretation should be contextualised by industry norms, company size, and growth sustainability.

Why is the PEG Ratio Important for Investors?

Using the P/E ratio alone can be misleading because it doesn’t consider whether a company is growing rapidly or slowly. A high P/E might scare you away, but a low PEG could reveal a hidden gem that is growing quickly and still reasonably priced. For investors, growth stocks in sectors such as IT, pharmaceuticals, or fintech often trade at high P/E ratios. PEG helps identify those with genuine growth potential versus those driven by hype.

Limitations of the PEG Ratio

The PEG ratio is useful, but it should not be relied on solely. The PEG ratio relies on accurate earnings growth estimates, which can be hard to predict and may vary across sources. Additionally, it does not account for external economic factors, market sentiment, or company-specific risks. Different industries have different typical PEG ranges; what’s high for one might be low for another. You should always use PEG alongside other financial metrics.

PEG Ratio vs P/E Ratio: Key Differences

ParameterPEG RatioP/E Ratio
DefinitionP/E ratio divided by EPS growth rateStock price divided by EPS
FocusAdds growth perspective to valuationLooks only at current earnings
UsageHelps identify undervalued growth stocksCommon valuation metric
InterpretationPEG < 1 is undervalued; PEG > 1 overvaluedHigh P/E can indicate overvaluation or growth potential
ApplicabilityBest for growth-oriented investmentsApplicable across all stocks

How to Use the PEG Ratio in Investment Decisions

  • Screen stocks with a PEG below 1 for potential undervaluation.
  • Check industry averages to benchmark typical PEG values.
  • Combine PEG with other ratios, such as Return on Equity (ROE), Debt levels, and cash flow, to get a fuller picture.
  • Utilise PEG in conjunction with qualitative analysis, including company management, sector trends, and economic outlook.
  • Remember, it’s a tool for long-term investing, not a daily market timing device.

Conclusion

The PEG ratio helps investors balance current stock prices with expected earnings growth. Unlike the P/E ratio, PEG provides a clearer view of whether a stock is undervalued or overpriced relative to its growth prospects. Used wisely alongside other financial data, it can guide better investment choices in India’s diverse stock market. Understanding PEG could lead to improved chances of long-term gains.

FAQs 

1. Can the PEG ratio be negative?

No, since it uses growth rate in the denominator, a negative or zero growth rate means PEG is not meaningful.

2. What PEG ratio is considered good in India?

Generally, a PEG below 1 is attractive, but it varies by sector and economic conditions.

3. How reliable is the EPS growth rate for PEG?

It depends on analyst estimates and past company performance, which can sometimes be inaccurate.

4. Can the PEG ratio predict stock price movement?

Not directly. It helps assess value vs growth, but should be combined with other data to forecast price trends.

Disclaimer and Disclosure 

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