The price-to-earnings growth, or PEG ratio, is meant to help investors calculate the value of stocks with high growth rates, since traditional metrics don't always work for growing companies. However, the PEG ratio needs to account for dividend yields in order to provide the true picture of a stock's valuation.
What is the PEG ratio?
When using the price-to-earnings (P/E) ratio to value stocks, you're only looking at a stock's current earnings. In other words, the ratio tells you how much you'll pay for the company's current earnings -- or, more specifically, its last 12 months or next 12 months of earnings.
However, businesses that are growing faster tend to trade for higher valuations. After all, it makes sense that investors are willing to pay more for a rapidly growing business.
As of this writing, Apple trades for 11 times its trailing 12 months' (TTM) earnings, while Microsoft trades for nearly 41 times its TTM earnings. But that difference in P/E ratios alone doesn't necessarily mean that Apple is a better value than Microsoft. We need to take growth into account.
In order to calculate a PEG ratio, simply divide the stock's P/E ratio by the company's expected earnings growth rate.
It isn't accurate for high-dividend stocks
Simply put, a high dividend can make a company's earnings growth seem slower than it actually is. Instead of reinvesting all of its profits in the business in order to grow earnings, it distributes a chunk of those earnings to shareholders. So this must be accounted for in order to accurately value a company while taking its earnings growth into account.
Adjusting the ratio for dividends
In order to calculate a dividend-adjusted PEG ratio, we need to add the stock's dividend yield to its expected annual growth in the denominator of the PEG ratio formula listed above. Mathematically, our formula now looks like this:
Using our previous example of Apple, let's calculate its PEG ratio and its dividend-adjusted PEG ratio in order to illustrate the difference this makes.
First, Apple's stock trades for just under $100 as of this writing, and the company earned $8.99 over the last 12 months. Thus our P/E ratio is 11.1. According to S&P Capital IQ, Apple's estimated earnings growth rate over the next three years is 9%. This implies that Apple's PEG ratio is 1.23.
However, Apple pays a dividend yield of 2.3%. Adding this to the 9% projected earnings growth gives a total of 11.3%. Our dividend-adjusted PEG ratio formula reveals a new ratio of 0.98. In other words, Apple is significantly cheaper than its PEG ratio makes it appear.
So the next time you're sizing up different dividend-paying investments, be sure to use the dividend adjusted PEG ratio to help you pin down their true value.
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