The PEG Ratio

A useful measure of value in some circumstances

The PEG ratio, or Price/Earnings to Growth ratio, provides a comparison of the price to earnings ratio (P/E ratio) to the earnings per share growth rate (EPS growth rate).

PEG ratio (PEG) = P/E ratio / EPS growth rate

Generally, a company with a high EPS growth rate will have a higher P/E ratio. Just using the P/E ratio as a valuation measure would make high EPS growth companies appear overvalued relative to others.

By dividing the P/E ratio by the EPS growth rate, the resulting ratio is better for comparing companies with different growth rates.

Peter Lynch argued in his 1989 book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its (EPS) growth rate". This means that a fairly-valued company should have its PEG equal to 1.

From a value-investing perspective, a lower PEG (less than one is more desirable than a higher ratio (greater than one).

The P/E ratio used in the calculation may be trailing (using previous annual reported EPS), or projected (forcasted). The annual EPS growth rate used is usually the expected EPS growth rate for the next year.

In his book, Peter Lynch argued that ... in general, a P/E ratio that's half the (EPS) growth rate is very positive, and one that's twice the growth rate is very negative. His analysts used the PEG all the time when choosing stocks for their mutual funds.


PEG Ratio as a Value Indicator

The PEG is a widely employed indicator of a stock's possible true value. Similar to the P/E ratio, a lower PEG means that the stock is more undervalued.

Because the PEG also accounts for growth, it is seen to be a more useful measure by some.

A PEG of 1 suggests that a stock is reasonably valued given the expected EPS growth.


Uses of the PEG Ratio

The ratio is commonly used to provide one measure of stock value, and is provided by various sources of financial and stock information. My online stock broker is my source.

Some points related to its use include ...

• despite its wide use, it is only a rule of thumb and has no theoretical basis
• it is generally only applied to 'growth' companies, companies growing earnings significantly faster than the market
• the use of the ratio with low EPS growth companies is considered to be highly questionable.
• because different stock sectors have different growth characteristics, comparing the PEG for a company with its sector may provide a more useful result.

Advantages and Disadvantages

The PEG ratio offers an indication of whether a company's high P/E ratio reflects an over-valued stock price, or is a reflection of favorable growth prospects for the company.

The PEG is less appropriate for use with low-growth companies. Large, well-established companies may offer little opportunity for growth.

The PEG is also less appropriate for use with small high-risk speculative companies that might have a low P/E due to their very low price, accompanied by a high EPS growth caused by a one-year doubling of the share price from a very low level; for example, from 0.50c to $1.00.

A company's EPS growth is an estimate, is subject to the limitations of projecting future events, and can change due to any number of factors.

Also, the company EPS growth used in the PEG does not account for the overall growth of the economy and has no correction for inflation. For example, a company with growth equal to the rate of inflation is not growing in real terms.

To Conclude

The PEG ratio may be a useful value-investing measure if used in conjunction with other measures of value, and if used for higher-growth companies for which its use is considered to be most appropriate.

The articles below examine the importance of each of the related measures in more detail.

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Related Articles

Price earnings ratio - a quick and easy (and hence commonly used) ratio for valuing stocks.

Earnings per share - a commonly used measure of profitability that should be use with other indicators.

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