PEG: How to find growing company at cheaper valuation?

It’s good when you find a growing company and invest in it. But it’s great when you invest in a growing company at the cheap valuations.

When you shortlist a growing company then it does not mean that you straight forward invest in it at any price.  
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Rather you should try to find the price levels which are right for the investment.

The valuation metrics

One such metrics which can help you in finding a growing company at cheap valuations is PEG ratio which is Price Earnings to Growth ratio.

It is actually a derivative of PE ratio which can be written as:

• PEG = PE/Growth rate

When,

• PEG > 1, the company is considered overvalued
• PEG < 1, the company is considered undervalued and can be a good investment choice

The important thing to consider while calculating the Peg ratio is the right and the realistic calculation of the growth rate.

​Any unrealistic assumption can make this ratio to give extreme values that are not reliable. 

​Understanding the concept

Let us understand with the help of an example: The two companies A & B have the following financials: ​

Company A

• P/E ratio: 15
• ​Realistic growth rate: 20%
• ​PEG: 0.75

Company B

• P/E ratio: 20
• Realistic growth rate: 15%
• PEG: 1.33

• On the basis of P/E ratio, the company B is preferred over the company A. As high PE indicates that the investors are expecting higher returns from the company
• The realistic growth rate of company A > rate of company B
• But the PEG ratio changed the preference from Company B to Company A
• ​The PEG of company A is 0.75 < 1 (undervalued), hence it is considered a good investment choice than Company B whose PEG is 1.33 > 1 (overvalued)

The shortcomings

• The PEG ratio gives results by focusing only on the earnings growth rate of the company. The Cash flow statement, dividends, and revenue growth are also important to evaluate the company.
• PEG is useful to analyze the small and mid cap companies. It loses its effectiveness when evaluating the large or blue chip companies, for example, a large company may give dividend regularly but have little growth rate will be having PEG > 1.
• As the growth rates are projected, error in projecting the growth rates can give misleading results.

Conclusion

It is true that PEG ratio is an effective tool to evaluate the stock.

​But if it is used in conjunction with other statements like cash flow statement, Revenue growth, and dividend statements, can give wonderful results.