Financial Modeling for Kids: Understanding Price-Earnings Growth (PEG Ratio)

Introduction to Price-Earnings Growth

In this section, we will explore the concept of Price-Earnings Growth (PEG) ratio and what it means for companies. The PEG ratio is like a special tool that helps us understand if a company is a good investment. We use it to see how a company's price (how much people are willing to pay for it) compares to its earnings growth (how much money it makes).

Price-Earnings Ratio (P/E Ratio)

The Price-Earnings ratio is a way to measure how much money people are willing to pay for every dollar a company earns. It is like knowing how much a toy costs compared to the number of stickers you can buy with the money you have. We calculate it by dividing the price of a company's stock by how much money it makes:

P/E Ratio = Stock Price / Earnings

For example, if a company's stock costs $50 and it earns $2, the P/E ratio would be 25 ($50 / $2).

Understanding Earnings Growth

Earnings growth tells us how fast a company is making more money over time. It shows us if the company is doing well and getting better at making money. We calculate earnings growth by comparing how much money the company made this year to what it made last year:

Earnings Growth Rate = (This Year's Earnings - Last Year's Earnings) / Last Year's Earnings

For example, if a company made $10 million last year and it made $12 million this year, the earnings growth rate would be 20% [($12 million - $10 million) / $10 million].

The PEG Ratio

Introduction to the PEG Ratio

The PEG ratio is a special number we get by combining the P/E ratio and the earnings growth rate. It helps us decide if a company is a good investment. We calculate it like this:

PEG Ratio = P/E Ratio / Earnings Growth Rate

For example, if a company has a P/E ratio of 20 and an earnings growth rate of 15%, the PEG ratio would be 1.33 (20 / 15).

What the PEG Ratio Tells Us

The PEG ratio helps us know if a company's stock is a good deal or not based on how much it is growing. If the PEG ratio is less than 1, it means the stock might be a good deal because it is growing faster than people think. If the PEG ratio is more than 1, it means the stock might not be such a good deal because it is not growing as fast as people expect.

What Different PEG Ratios Mean

1. PEG Ratio < 1: If the PEG ratio is less than 1, it means the stock might be a good deal. People may not realize how fast the company is growing, so it could be a good investment.
2. PEG Ratio = 1: If the PEG ratio is equal to 1, it means the stock is priced just right. People think the company's growth is fair and they are willing to pay for it.
3. PEG Ratio > 1: If the PEG ratio is greater than 1, it means the stock might not be a good deal. People are expecting a lot of growth and are willing to pay more for it, but it might not be worth it.

Limitations of the PEG Ratio

Comparing Companies in the Same Field

The PEG ratio is most helpful when we compare companies that are doing similar things. It's like comparing soccer players on a soccer field instead of mixing them with basketball players. Different fields have different expectations, so comparing them doesn't tell us much.

Making Sure the Numbers Are Right

We need to be careful with the numbers we use to calculate the PEG ratio. If we use numbers that are too high or too low, we might get the wrong idea about the company. It's important to use numbers that make sense and are reliable.

Some Companies Change a Lot

Some companies' earnings go up and down a lot because of the economy. It's like riding a roller coaster. The PEG ratio might not show this well, so we need to be careful when we look at it for these companies.

PEG Ratio and Interest Rates

How Interest Rates Matter

Interest rates can make a big difference in the PEG ratio and how we think about stocks. When interest rates are low, people are willing to pay more for future growth because they don't get much from saving money. When interest rates are high, people want to get more back from their investments, so they don't pay as much for future growth.

Thinking About Interest Rates

When we look at the PEG ratio, we also need to think about interest rates. Interest rates can change what people think is a good investment. If interest rates go up, people might think a stock is not such a good deal anymore because they can get more money by saving it instead.

Looking at the Past

Seeing How Companies Did Before

To understand how a company is doing now, we can look at how it did in the past. We can calculate the average growth rate of a company's earnings over a few years and compare it to the P/E ratio during that time. It helps us see if the company is getting better over time.

Understanding the Past PEG Ratio

The past PEG ratios help us see how people thought about the company's growth before. If the past PEG ratio is going down, it means people started to think the company would grow more. This might mean the stock became more valuable and people were willing to pay more for it.

Conclusion

Financial modeling might sound complicated for kids, but it's actually a way to understand if a company is a good investment or not. We use a special tool called the PEG ratio to help us. It compares how much money a company is making to how much its stock costs. If the PEG ratio is less than 1, it means the stock might be a good deal because the company is growing faster than people think. If the PEG ratio is more than 1, it means the stock might not be a good deal because the company is not growing as fast as people expect. But we have to be careful when using the PEG ratio. We can't compare companies from different fields because they have different expectations. We also need to use reliable numbers and consider how interest rates can affect people's thinking about investments. Finally, we can look at the past to see how the company did before and if people started to think it would grow more. Financial modeling helps us make smart decisions about investments, but we need to consider many things to get the full picture. It's like putting together a puzzle to see if it's a good idea to buy a company's stock or not. 

This article takes inspiration from a lesson found in FINN 3103 at the University of Arkansas.