Understanding the PEG ratio

If there are two identical companies which are similar in every regard except that one company is projected to grow at a higher rate than the other, then isn't it natural for a rational investor to pay more for the high-growth company?

This analogy underscores an important shortcoming of the P/E metric i.e it ignores expected growth rates. The P/E ratio values all companies based only on its historical earnings and this is inappropriate for comparing companies which are in different stages of their life cycles. If two companies have the same P/E ratio, it is likely that many people will reach a very cursory (but incorrect) conclusion that both these companies are trading at the same relative valuation. But we know that a declining company is not likely to repeat its earnings, while the company in its growth phase is likely to increase its earnings in the future.

To rectify this shortcoming of the P/E ratio, the PEG or 'price-earnings to growth' ratio was devised. This metric adjusts a company's P/E by dividing the P/E with the company's expected growth rate. In a sense, the metric tells us what the P/E is per unit of expected growth. For example, a company trading at a P/E of 15 and having an expected earnings growth of 20 per cent would have a PEG of 0.75.

If a company has a higher PEG ratio, it means that even after accounting for its expected growth, it is more expensive than the one with a lower PEG. So, when used for companies having different growth rates, the PEG ratio gives a better picture of which company is more expensive. The generally accepted thumb rule is that a PEG of 1 implies that a company is fairly valued. Anything less than that is considered to be undervalued and vice versa.

Advantages
Apart from being more refined than the P/E ratio, the PEG ratio is also fairly straightforward to calculate and is available on many websites. It is also intuitively understandable and gives investors a quick way to value companies having different growth rates. PEG is also more appropriate when a company's future is unlikely to resemble its past. For example, Reliance Industries is evolving: from being a pure-play petrochemical refiner in the past, it is more likely to be a technology/retailing giant in the future.

Disadvantages
The fundamental problem with this metric is the same that is inherently embedded in every forward-looking estimate i.e the predictability (or the lack thereof) of the future. The PEG ratio is highly dependent on the estimates of earnings growth and we all know that predictions about a company's future earnings, even those of experts/analysts/super-smart people etc., are anything but accurate.

Another limitation of this metric is that it is not very useful for those companies whose valuations are not driven by earnings growth. For example, the book value would be more relevant for companies that are going to be liquidated, real estate investment trusts etc. Investors also have to be careful while relying upon the PEG ratios from different sources, as there could be different values, with each having different underlying assumptions.

Also read in this series

Understanding the P/E ratio
Understanding the P/B ratio
Understanding enterprise value
Understanding discounted cash flow