Definition
The Price to Earnings Growth (PEG) ratio is a valuation metric that compares a company's price-to-earnings (P/E) ratio to its expected earnings growth rate. It is used to determine a stock's value while considering the company's growth potential.
Formula
PEG = (Price/Earnings) / Earnings Growth Rate
How to use the valuation method
The PEG ratio is used by investors to assess whether a stock is overvalued or undervalued relative to its growth prospects. A PEG ratio of 1 suggests that the stock is fairly valued, while a PEG ratio below 1 indicates that the stock may be undervalued given its growth potential. Conversely, a PEG ratio above 1 may suggest that the stock is overvalued.
Which industries it work best in
The PEG ratio works best in industries with stable and predictable growth rates, such as technology and consumer goods, where companies often have consistent earnings growth.
Which industries it does not apply to and why
The PEG ratio is less applicable in industries with volatile or unpredictable earnings, such as commodities or cyclical industries, because the earnings growth rate can be difficult to estimate accurately.
Summary
The PEG ratio is a useful tool for evaluating a stock's valuation relative to its growth prospects. It is most effective in industries with stable growth and less reliable in sectors with volatile earnings.
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