When computing the PEG ratio for a stock, how is a company's earnings growth rate determined?

Formula for PEG Ratio

• PEG ratio = P/E ratio / earnings growth rate
• P/E ratio = Price per share / EPS

Example 

         ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years.20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66         XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years.30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75

Explanation

         Using the examples above, the PEG ratio tells us that ABC Industries stock price is higher than its earnings growth. This means that if the company doesn't grow at a faster rate, the stock price will decrease. XYZ Micro's PEG ratio of 0.75 tells us that the company's stock is undervalued, which means it's trading in line with the growth rate and the stock price will increase.

Stock theory suggests that the Stock market should assign a PEG ratio of one to every stock. This would represent theoretical equilibrium between the market value of a stock and anticipated earnings growth. For example, a stock with an earnings multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of one.