Using PEG Ratio Explained, versus P/E, EV/EBITDA and FCF Yield - The Ultimate Valuation Showdown!

When purchasing anything significant in life be it a car, home, or even choosing a smartphone you naturally engage in careful comparison. You compare brands, scrutinize pricing trends, and consider value for money. Similarly, when investing in stocks, valuation is paramount. It ensures you're not overpaying for an expensive stock. Valuation metrics act as a compass for investors, offering direction through the noise of financial markets. However, what's crucial is how you navigate with that compass.

What is the PEG Ratio and Why Do People Use It?

The PEG Ratio, or Price/Earnings to Growth Ratio, blends a company's price-to-earnings (P/E) ratio with its expected earnings growth rate. Rather than offering a definitive measure of whether a stock is overvalued or undervalued, the PEG ratio helps investors compare how ‘expensive’ or ‘cheap’ a stock is relative to its projected growth. It’s most useful when comparing companies within the same industry or sector.

P/E Ratio vs. PEG Ratio: What’s Different?

The P/E ratio measures what investors are willing to pay today for each dollar of current earnings. But it ignores future growth, leaving high-growth stocks looking deceptively expensive. The PEG Ratio fills this gap by dividing the P/E ratio by the company's expected earnings growth rate. Thus, PEG provides a growth-adjusted valuation.

The difference between Forward PE ratio and PEG Ratio ? : The Forward P/E ratio measures how a stock is priced based on expected earnings over the next year. The PEG ratio takes it a step further by factoring in the company’s expected earnings growth helping investors judge whether a stock’s valuation is justified by how fast it’s projected to grow.

What Is Considered a Good PEG Ratio?

A good PEG ratio is typically around 1, indicating that the stock’s price is in line with its expected growth. A ratio below 1 may suggest the stock is undervalued relative to its growth potential, while a ratio above 1 could indicate overvaluation.

When evaluating the PEG ratio, it's essential to also consider the industry. For example, simply comparing Meta (Facebook) and Netflix based on their PEG ratios could lead to misleading conclusions if we don't account for the unique characteristics of their industries.

Meta, as a more mature tech company, operates in the digital advertising space with slowing growth projections. This results in an above average PEG ratio despite a more reasonable P/E ratio, as its earnings growth is moderating. 

On the other hand, Netflix operates in the rapidly growing streaming market with aggressive content production strategies, leading to high growth potential that justifies its high P/E ratio and higher PEG ratio.

Industry dynamics and growth expectations play a critical role in shaping these ratios. Therefore, it's crucial to interpret PEG ratios with an understanding of industry trends, as they greatly impact growth projections and, by extension, valuation metrics.

What is PEG Ratio Used For? Should You Use it for All Companies?

PEG Ratios are especially valuable for growth-oriented investors targeting companies in expansion phases. But it's not universally applicable. Mature businesses with steady, predictable cash flows might be better valued using metrics like dividend yield or FCF yield, as their growth rates are usually relatively modest.

Examples of PEG Ratio Calculations

Let’s illustrate with a simple example:

Company A: Stock price = $100, EPS = $5 (P/E = 20), projected growth rate = 10%

PEG = 20 / 10 = 2 (Relatively expensive given growth)

Company B: Stock price = $100, EPS = $5 (P/E = 20), projected growth rate = 25%

PEG = 20 / 25 = 0.8 (More attractively valued given robust growth)

Common Pitfalls and Mistakes Beginners Make

Beginners frequently rely too heavily on optimistic growth projections, resulting in misleadingly low PEG ratios. Always question assumptions behind growth estimates and cross-check with historical performance and sector averages.

Getting a Negative PEG Ratio?

A negative PEG ratio can arise from either a negative PE ratio or a negative growth projection. If both are negative, the resulting positive PEG ratio becomes misleading. Therefore, understanding the components of the PEG formula is crucial when interpreting the metric.

Using the PEG ratio in such cases can lead investors to mistakenly believe that the company is attractively valued when, in reality, it’s in financial distress. 

A negative PEG ratio (with negative values for P/E and growth) should not be used because it doesn’t offer any meaningful insight.

What Growth Investors MISS when using PEG Ratio

Relying exclusively on PEG overlooks several critical elements:

• Debt Levels: Highly leveraged firms might have attractive PEG ratios but pose hidden risks.
• Capital Efficiency: How efficiently management allocates capital can dramatically affect long-term growth prospects but isn’t captured by PEG alone.
• Quality of Earnings: PEG ignores whether earnings growth is sustainable or temporarily inflated by accounting tactics.

The Ultimate Valuation Showdown!

PEG ratio isn’t the only player in the valuation game. Here are several widely-used metrics:

Other Common Valuation Metrics

• EV/EBITDA: Measures a company’s total value relative to earnings before interest, taxes, depreciation, and amortization. Useful for companies with significant capital investments.
• P/FCF (Price to Free Cash Flow): Highlights cash generated after necessary capital expenditures—a powerful indicator of financial health.
• P/Sales: Useful for companies without profits, comparing market valuation to revenues.
• P/Book: Compares market value with book value—useful in sectors like banking and insurance.

Which is the Best Valuation Method to Use?

No single metric reigns supreme; context and industry dictate optimal valuation methods.

Stock Valuation Secrets You Might Not Have Known

Absolute vs. Relative Stock Valuation Methods

All metrics discussed thus far are relative—they measure stocks against peers or historical norms. Absolute valuation methods, like Discounted Cash Flow (DCF) or Discounted Net Income, aim to measure a company's intrinsic value based purely on its own future cash flows or earnings, irrespective of market sentiment.

Neither absolute nor relative valuation is universally better—it depends on the investor’s objectives and the context of the stock being analyzed. Here’s when to use each method:

Absolute Valuation is ideal for investors who want a deep dive into a company’s intrinsic value and are comfortable making long-term projections.

Relative Valuation is better for those looking for a quick comparison between similar companies or who are concerned with short-term market conditions.

Final Thoughts

No single valuation method tells the whole story. Smart investors utilize a blend of relative and absolute methods to craft a nuanced investment thesis. The PEG ratio offers insightful growth-adjusted context, while metrics like EV/EBITDA and P/FCF provide operational clarity. Ultimately, the best investors know valuation isn't merely a mechanical process, it's an art informed by experience, judgment, and rigorous analysis.