What is the PEG Ratio?
The PEG (Price/Earnings-to-Growth) ratio is a valuation metric that improves upon the traditional P/E ratio by incorporating a company's earnings growth rate. It was popularized by legendary investor Peter Lynch.
While the P/E ratio tells you how much you're paying for each dollar of earnings, the PEG ratio tells you how much you're paying relative to the company's growth potential.
The PEG Formula
PEG Ratio = P/E Ratio ÷ Earnings Growth Rate
Example Calculation:
- P/E Ratio: 25
- Earnings Growth Rate: 20% per year
- PEG Ratio: 25 ÷ 20 = 1.25
How to Interpret PEG Values
PEG < 1.0 — Potentially Undervalued
The stock may be undervalued relative to its growth rate. You're paying less than $1 for every percentage point of growth. This is generally considered attractive.
PEG = 1.0 — Fairly Valued
The stock is fairly valued. The P/E ratio is in line with the growth rate. Peter Lynch considered this "fair value."
PEG > 1.0 — Potentially Overvalued
The stock may be overvalued relative to its growth rate. You're paying more than $1 for every percentage point of growth. Exercise caution.
Why Use PEG Instead of Just P/E?
P/E Ratio Limitations
- • Doesn't consider growth
- • High P/E looks expensive
- • Misleading for growth stocks
- • Ignores future potential
PEG Ratio Advantages
- • Includes growth rate
- • Fair comparison across industries
- • Better for growth stocks
- • More complete valuation picture
Real-World Example
Comparing Two Stocks:
Stock A (Value Stock)
- P/E Ratio: 15
- Growth Rate: 10%
- PEG: 15 ÷ 10 = 1.5
Stock B (Growth Stock)
- P/E Ratio: 30
- Growth Rate: 40%
- PEG: 30 ÷ 40 = 0.75
Analysis: Even though Stock B has a higher P/E ratio (30 vs 15), it has a lower PEG ratio (0.75 vs 1.5), suggesting it may be the better value when growth is considered.
Important Limitations
- Growth Rate Estimates: PEG relies on future growth estimates, which can be inaccurate or overly optimistic.
- Negative Earnings: PEG doesn't work for companies with negative earnings or no growth.
- Industry Variations: Different industries have different typical PEG ranges. Compare within sectors.
- Short-Term Volatility: Growth rates can fluctuate, making PEG values unstable in the short term.
Complementary Valuation Metrics
PEG is powerful, but should be used alongside other valuation ratios:
PEGY Ratio
For dividend stocks—adds yield to growth rate
P/S (Price-to-Sales)
For unprofitable high-growth companies
P/B (Price-to-Book)
Value plays and asset-heavy industries
ROE (Return on Equity)
Management efficiency indicator
Profit Margin
Profitability and competitive advantage
Beta
Volatility and risk measurement
Debt-to-Equity
Financial leverage assessment
Best Practices
- Compare Within Industries: Tech stocks will have different PEG norms than utilities.
- Use Multiple Metrics: Don't rely on PEG alone. Consider PEGY, P/S, P/B, ROE, margins, and debt levels.
- Verify Historical Growth: Ensure growth rates are sustainable based on past performance.
- Use 3-5 Year Growth Rates: Longer-term rates are more reliable than annual figures.
- Exercise Caution: If a PEG seems unusually attractive, investigate thoroughly before investing.
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