PE ratio that is price to earnings ratio is the most basic concept related to stock market, it can be calculated with the help of the following formula – Market price of share/earnings per share (EPS)
Market price is the current price of stock at which can be bought and sold while EPS is the earning of the company that is left for shareholders after deducting all expenses and interest paid by the company divided by the number of outstanding equity shares of the company.
As one can see from above that PE ratio takes into account only past earning and it does not takes into account the future potential growth rate in profits of a company. That’s where PEG ratio that is Price/Earnings to Growth ratio can be helpful. PEG ratio can be calculated using the following formula = PE ratio/Annual EPS growth
If an investor uses PEG ratio along with PE ratio then he or she can have a better idea about the future potential of the stock. Let’s see it with the help of an example, suppose there are two companies A and B, company A has a PE ratio of 25 and annual growth rate of 10% and company B has a PE ratio of 30 and annual growth rate of 20%. Then the PEG ratio of Company A will be 2.5 and PEG ratio of Company B will be 1.5. Evidently if an investor would have seen only PE ratio then he or she would have selected company A because of its low PE as compared to company B, but after seeing PEG ratio an investor will go for company B because higher growth companies will have lower PEG ratio and vice versa.