Are There Any Shortcomings in Using PEG?
Understanding PEG ratio and its use in stock valuation is easy. PEG can assist investors in effective investment decision-making because it considers both the P/E ratio and an expected growth rate. On the other hand, the PEG ratio is not always the best way to evaluate a potential investment.
The following are shortcomings in using PEG ratio.
1. Growth estimates are not always accurate as they may be based on analysts’ expectations and not on real growth potential. Moreover, estimates may change at any given moment.
2. Dividends are excluded from the PEG ratio calculation. In fact, the PEG ratio overlooks a company’s ability to increase shareholder value.
3. Inflation is not included in the PEG ratio calculation. If the growth of a company is the same as inflation, the PEG is a useless figure as, in fact, the company has no growth.
4. The PEG ratio is not really useful when assessing cyclical stocks, i.e. stocks that are closely related to the ups and downs of the economy. Typically, cyclical stocks demonstrate an increased demand when the economy grows and fall rapidly when economic growth is slowing down. As the earnings of cyclical companies tend to be extremely inconsistent, the PEG ratio is not practical.
5. Companies with low growth produce irrational PEG ratios that cannot be used for proper stock valuation.
6. Companies that have zero growth cannot be included in PEG calculations as dividing by zero is not possible.
In spite of its shortcomings, the PEG ratio is a reliable valuation method to identify undervalued, overvalued or fairly priced stocks. Generally, the lower the PEG, the better the value of a stock as investors would be paying less per unit of earning growth. However, the PEG ratio should be used complementary with other valuation methods to achieve reasonable results and should not be less than one.