The price-to-earnings ratio is among the most prominent metrics that investors use when making investment decisions. It is straightforward to calculate and also provides a tool for investors to compare various stocks. Another reason why investors prefer the P/E ratio is that they can use it in other useful ratios. One of these includes the P/E to Growth ratio.
What is the P/E to Growth Ratio?
The P/E to Growth ratio (PEG) considers a stock’s P/E ratio and the growth rate of its earnings for a specific period. The PEG ratio enhances the P/E ratio by considering any estimated growth in a company’s income. It is one of the limitations of the P/E ratio, which the PEG ratio addresses. Through the PEG ratio, investors can get valuable insights into a stock’s level of valuation.
How to calculate the P/E to Growth Ratio?
Investors can use the following formula to calculate a company’s P/E to Growth ratio.
P/E to Growth Ratio = P/E Ratio / EPS Growth
Similarly, investors can expand the formula as follows.
P/E to Growth Ratio = (Price / EPS) / EPS Growth
Usually, calculating the P/E ratio is straightforward. It is also available on most stock markets for publicly-listed companies. However, obtaining an accurate EPS growth rate for a specific stock may be difficult. Investors can get these estimates from specialized sources for publicly-listed companies. Once they have both the figures, they can easily calculate the PEG ratio for the stock.
Example
An investor wants to decide between investing in two stocks. The first stock is from Red Co., which has a market price of $100. The company’s EPS in the previous accounting period was $25 per share. Stock analysts believe that the EPS will grow by 20% in the next period. Red Co.’s P/E ratio is as below.
P/E Ratio = Current Share Market Price / Earnings Per Share
P/E Ratio = $100 / $25
P/E Ratio = 4
Similarly, Red Co.’s P/E to growth ratio will be as below.
P/E to Growth Ratio = P/E Ratio / EPS Growth
P/E to Growth Ratio = 4 / 20
P/E to Growth Ratio = 0.2
On the other hand, the investor has the option to invest in Blue Co.’s stock as well. Blue Co.’s current stock price in the market is $100 as well. Similarly, its EPS for the last period was $32. Market analysts believe the company’s EPS will grow by 10% in the next period. Therefore, the company’s P/E ratio is as below.
P/E Ratio = Current Share Market Price / Earnings Per Share
P/E Ratio = $100 / $32
P/E Ratio = 3.125
Similarly, Blue Co.’s PEG ratio is as below.
P/E to Growth Ratio = P/E Ratio / EPS Growth
P/E to Growth Ratio = 3.125 / 10
P/E to Growth Ratio = 0.3125
Some investors may prefer investing in Red Co.’s stocks due to the lower P/E ratio. However, according to the PEG ratio, Blue Co.’s stocks have a better potential for growth. Regardless, investors must understand that the PEG ratio depends on the accuracy of the forecasted EPS growth.
Conclusion
P/E ratio is a widely used financial metric that allows investors to make decisions between investments in stocks. However, it fails to reflect the potential growth in earnings in the future. That is where the P/E to growth ratio is useful. The PEG ratio considers the relationship between a stock’s P/E ratio and its growth rate.
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