📊 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 = 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 = 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 Alone
- • Doesn't consider growth
- • High P/E looks expensive
- • Misleading for growth stocks
- • Ignores future potential
✅ PEG Ratio
- • 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
Conclusion: 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
- 1️⃣Growth Rate Estimates: PEG relies on future growth estimates, which can be inaccurate or overly optimistic.
- 2️⃣Negative Earnings: PEG doesn't work for companies with negative earnings or no growth.
- 3️⃣Industry Variations: Different industries have different typical PEG ranges. Compare within sectors.
- 4️⃣Short-Term Volatility: Growth rates can fluctuate, making PEG values unstable in the short term.
✅ Best Practices
- Compare Within Industries: Tech stocks will have different PEG norms than utilities.
- Use Multiple Metrics: Don't rely on PEG alone. Also consider PEGY, P/E, debt levels, and cash flow.
- Check Historical Growth: Verify that the growth rate is sustainable based on past performance.
- Look at 3-5 Year Growth: Use longer-term growth rates, not just one year.
- Be Conservative: If a PEG seems too good to be true, investigate why before investing.
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