Price/Earnings to Growth and Dividend Yield (PEGY Ratio)
What Is Price/Earnings to Growth and Dividend Yield (PEGY Ratio)?
The price/earnings to growth and dividend yield (PEGY ratio) — otherwise called the "dividend-adjusted PEG ratio" — was created by famed value investor Peter Lynch. By creating the PEGY ratio, Lynch tried to improve upon the price-to-earnings (P/E) valuation metric most investors use when attempting to determine the value of a stock.
Lynch believed that to accurately evaluate the opportunity a stock represents as an investment, the investor ought to likewise factor in the stock's future growth prospects and dividend yield. The PEGY ratio includes both of these factors and is a metric investors use to identify undervalued stocks.
Understanding Price/Earnings to Growth and Dividend Yield (PEGY Ratio)
Both the PEGY ratio and the price/earnings-to-growth (PEG Ratio) are evolutions of the price-to-earnings (P/E) ratio. One limitation Lynch realized when utilizing the P/E and PEG ratios for stock evaluation was that these metrics didn't take the potential for future earnings growth or dividend payments into consideration when dissecting the stock.
Because of this, mature companies with a lower growth rate that pay dividends were unreasonably punished on the off chance that they were just evaluated utilizing the P/E or PEG ratios. Lynch wanted a more accurate approach to evaluating these companies and in this way created the PEGY ratio that added projected growth and dividend yield into the equation.
The PEGY ratio is calculated as the P/E ratio divided by the sum of the projected earnings growth rate and the dividend yield, as displayed in this formula:
Example of Price/Earnings to Growth and Dividend Yield (PEGY Ratio)
Let's use the PEGY ratio to evaluate a company as a potential investment.
Company ABC has a P/E ratio of 9, a projected earnings growth rate of 15% for the next year, and a dividend yield of 4.5%. Utilizing these numbers, we arrive at the following PEGY ratio:
A PEGY ratio below 1.0 is considered low and represents a potential investment opportunity as it indicates the stock has high dividend yields or potential growth and is currently selling at a bargain price.
The Bottom Line
It's important to note the PEGY ratio has its disadvantages. It uses the company's projections for growth and not the real growth the company achieves. Therefore, the ratio isn't guaranteed to be an accurate reflection of future performance.
When computing any of these ratios, it is consistently really smart to use just operating and recurring income in the calculation of earnings, to use a lower consensus estimate for the growth rate, and to use projected future dividends as opposed to current dividends. While the PEGY ratio doesn't tell the whole story of a stock's potential for appreciation, it provides investors with a starting point in their stock analysis.
Highlights
- As a metric for stock analysis, the PEGY ratio differs from the price-to-earnings (P/E) ratio because it takes into consideration the stock's potential for future earnings growth and dividend payments.
- A PEGY ratio below 1.0 represents a potential investment opportunity as it indicates the stock has high dividend yields or potential growth and is currently selling at a bargain price.
- The price/earnings to growth and dividend yield (PEGY ratio) was developed by Peter Lynch, a legendary investor and fund manager.
