Tim Bennett looks at an improvement on the standard price/earnings ratio – the PEG ratio – and explains what it is and how you calculate it.
The price/earnings to earnings growth, or PEG, ratio is used as a rule of thumb to consider basic value while taking earnings growth into account. You get it by dividing a stock's p/e by the annual growth rate of its earnings per share. The lower a PEG the better, as it means a stock is cheap relative to its potential earnings growth. Thus firm A, a flashy biotech, might have a p/e of 100, but a growth rate of 50%, giving it a PEG of two, while firm B, a solid support services group with a p/e of ten and a growth rate of 7% has a PEG of 1.4. On the face of it, firm A seems more exciting, but the PEG ratio shows that in risk and reward (price and growth) terms, it is the more expensive.
• Entry from MoneyWeek's Financial glossary.