PEG Ratio
The PEG ratio divides the P/E multiple by the expected earnings growth rate expressed in percentage points, putting growth and price on the same page. It exists because a raw P/E penalises fast-growing firms, which look expensive on current earnings yet may be cheap once their growth is taken into account. A common rule of thumb treats a PEG near one as roughly fair, below one as potentially cheap for the growth on offer, and above one as dear. The ratio is a useful screen but a blunt instrument, since it assumes a near-linear link between growth and the justified multiple and leans entirely on a single, often optimistic, growth forecast.
Why it matters
Two firms on a P/E of 30 are not equally expensive if one grows earnings at 10 percent and the other at 30 percent. PEG normalises for exactly that. Divide the 30 P/E by the growth rate and the slow grower scores 3.0 while the fast grower scores 1.0, which flags the fast grower as the better value for its growth. The appeal is that it rescues high-P/E stocks from being dismissed on the headline multiple alone. The weakness is that the whole answer pivots on the growth number, and growth forecasts are the softest input in valuation, so a generous estimate quietly flatters the ratio.
Formulas
Worked examples
Stock X trades on a P/E of 30 and is expected to grow earnings at 10 percent. Stock Y trades on the same P/E of 30 but is expected to grow at 30 percent. Which looks better value on a PEG basis?
For Stock X the PEG is 30 divided by 10, which is 3.0. For Stock Y the PEG is 30 divided by 30, which is 1.0. Even though both carry the identical P/E of 30, Stock Y is far more attractive once growth is folded in, with a PEG at the fair-value benchmark of one against Stock X at three times that. The PEG corrects the impression, given by the raw P/E alone, that the two are equally priced. The caveat is that Stock Y’s appeal collapses if its 30 percent growth forecast proves optimistic.
Common mistakes
- ✗A PEG below one is always a buy. The PEG rests on a single growth forecast, so an over-optimistic growth estimate can make an expensive stock look cheap on this measure.
- ✗PEG removes the need to judge the P/E. PEG reframes the P/E using growth but does not fix the deeper issues of earnings quality and forecast reliability.
- ✗The relationship between growth and the justified multiple is exactly linear. PEG assumes near-linearity, yet valuation theory implies the justified P/E rises with growth in a more complex, non-linear way.
- ✗PEG works for any company. It needs a meaningful positive growth forecast, so it is unsuitable for firms with negative earnings or flat-to-declining growth.
Revision bullets
- •PEG divides the P/E by the expected earnings growth rate
- •It puts a high-P/E growth stock and a low-P/E slow grower on equal footing
- •A PEG near one is a rough fair-value benchmark
- •Below one can be cheap for the growth, above one can be dear
- •The ratio leans entirely on one growth forecast
- •It assumes a near-linear growth-to-multiple link, which is an approximation
Quick check
A stock trades on a price-to-earnings ratio of 24 and is expected to grow earnings at 12 percent a year. Its PEG ratio is
The main weakness of the PEG ratio is that it
Connected topics
Sources
- Titman & Martin, Ch. 8Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Discusses adjusting the P/E for growth and the practical limits of growth-based multiples.
- Damodaran on relative valuationDamodaran, A. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.Critiques the PEG ratio and the assumed linear relationship between growth and the multiple.