What Is the Price/Earnings-to-Growth (PEG) Ratio?
Let me explain the PEG ratio directly to you. It's a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings over a specific period. I use it to assess a stock's value while considering the company's expected earnings growth, giving you a more complete view than just the P/E ratio alone.
Key Takeaways
The PEG ratio builds on the P/E by including expected earnings growth in the mix. It acts as an indicator of a stock's true value. If the PEG is lower, that might mean the stock is undervalued. Remember, the PEG can vary between sources depending on the growth estimate used, like one-year or three-year projections. Aim for a PEG under 1.0, as that suggests relative undervaluation.
How to Calculate the PEG Ratio
You calculate the PEG ratio with this formula: PEG Ratio = (Price / EPS) / EPS Growth, where EPS is earnings per share. Start by finding or calculating the P/E ratio, which is the price per share divided by EPS. Then, get the expected growth rate from analyst estimates on financial sites. Plug those numbers in and solve for the PEG.
The accuracy here depends on your inputs. If you're looking at a published PEG, check what growth rate they used—historical rates might not match future expectations, and you could use one-year, three-year, or five-year rates. Sometimes you'll see 'forward PEG' for future growth and 'trailing PEG' for historical.
What Does the PEG Ratio Tell You?
A low P/E might seem like a bargain, but factoring in growth via PEG can change that picture. A lower PEG often means the stock is undervalued based on future earnings. This adjustment is key for high-growth companies with elevated P/E ratios.
The interpretation varies by industry and company, but generally, a PEG below 1.0 is desirable. As Peter Lynch noted, a PEG of 1.0 means fair value—equal P/E and growth. Above 1.0 suggests overvaluation, below indicates undervaluation.
Example of How to Use the PEG Ratio
Consider two hypothetical companies to see this in action. For Company A: price per share is $46, this year's EPS is $2.09, last year's was $1.74. That gives a P/E of 22, growth rate of 20%, and PEG of 1.1.
For Company B: price is $80, this year's EPS $2.67, last year's $1.78. P/E is 30, growth 50%, PEG 0.6. Company A has a lower P/E, but Company B's lower PEG shows it's a better value per unit of growth—investors pay less for its earnings potential.
Frequently Asked Questions
What makes a good PEG ratio? Generally, under 1.0 is good, signaling undervaluation; over 1.0 means potential overvaluation.
Is a higher or lower PEG better? Lower is better, especially below 1.0.
What does a negative PEG indicate? It comes from negative earnings or growth estimates, pointing to company troubles.
The Bottom Line
While P/E is popular, PEG adds growth estimates for a better value assessment. Reliable estimates are crucial—bad forecasts can mislead. Use it carefully to avoid projecting past growth naively into the future.
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