This key ratio compares the price to earnings ratio to a firm’s earnings growth rate to see whether a share is cheap or expensive.
For example, if last year’s earnings per share was 10p and the current year forecast is 12p the expected earnings growth rate is 20%. Say the P/E ratio – the relationship between the current share price and one year’s earnings per share – is 30 then the PEG ratio is 1.5 (30/20).
A PEG above 1 can be an indicator of an overvalued share, in this case possibly by as much as 50%. Below 1 the ratio can indicate a bargain – this is based on the idea that a P/E ratio of say 10 implies an earnings growth rate of 10%.
If you expect the company’s earnings to grow by 15% then the P/E of only ten suggests the share price undervalues expected earnings growth (the PEG is 10/15 or 0.67). Of course, the theory collapses if the earnings forecast turns out to be optimistic.