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PEG Ratio

Updated: Nov. 08, 2023Written By: Amanda ReaumeReviewed By:

The PEG ratio is a metric used to analyze growth stocks. It assesses a stock’s price to its earnings level and growth rate of those earnings per share, in evaluating the appeal of the valuation.

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Price/Earnings-To-Growth Ratio Meaning

The Price/Earnings-To-Growth ((PEG ratio)) is a financial metric that builds upon the price-to-earnings ratio (P/E ratio) to help investor assess the valuation of profitable growth stocks.

A company's price-to-earnings ratio is simply the price of its stock divided by the company's earnings per share. However, if two companies have the same price-to-earnings ratio but one company is experiencing 40% growth versus 10% growth for the other, the company with the higher growth by most assessments might be the more attractive investment.

Dividing a stock's P/E ratio by the company's growth rate helps investors incorporate expected future earnings into a measurable valuatio ratio. Investors should be mindful that no single valuation metric is a foolproof method for identifying undervalued stocks.

Tip: A stock with a low PEG ratio might not always be a better choice. High-growth companies are more likely to be volatile and have inconsistent earnings.

PEG vs. P/E Ratio

The P/E ratio of a company is calculated by taking a stock's price per share and dividing it by its annual earnings per share. This is done to determine what the ratio is between a company's annual earnings and its stock price. For example, if a stock earns $1.25 per share and has a stock price of $20 per share then the company's P/E ratio is 16x. That means that its share price is 16x its earnings.

A PEG ratio is reached by taking the P/E ratio and then dividing it by a company's growth rate over a specific period of time. For example, if the stock mentioned above grew 12% in the last year, its PEG ratio would be 1.33x (=16 / 12).

The PEG ratio includes a dimension that the P/E ratio leaves out, helping investors incorporate growth information into the valuation assessment.

Tip: There are online calculators that help determine the PEG ratio of a company.

Using The PEG Ratio Formula

The formula for calculating the PEG ratio is simple. Just divide the price/earnings ratio by the current (or forecasted) earnings per share growth rate.

Price Earnings Growth Ratio (PEG) = Price Earnings Ratio (P/E) / Earnings Per Share Growth Rate

This is a PEG Ratio equation. It says PEG Ratio = P/E Ratio/Earnings Growth Rate

PEG Ratio Equation (Seeking Alpha)

Price/Earnings Growth Examples

Here is an example of how comparing the PEG ratio of two companies can be useful in understanding the company's value better.

Two different companies sell cars: Acme Cars has a share price of $100 and earnings per share of $5 and earnings growth 15%, while Beta Cars has a share price of $50 and earnings per share of $2 and growth of 25%.

Acme Cars

  • Price per share= $100
  • Earnings per share this year = $5
  • Price / Earnings ratio = $100 / $5 = 20x
  • Growth = 15%
  • PEG ratio = 20 / 15% = 1.333

Beta Cars

  • Price per share= $50
  • Earnings per share this year = $2
  • Price / Earnings ratio = $50 / $2 = 25x
  • Growth = 25%
  • PEG ratio = 25 / 25% = 1.0

In the above example, while Acme cars appears to have a lower P/E ratio (20x, versus 25x for Beta), Beta actually carries the more attractive PEG ratio, however, due to its higher growth rate.

Benefits & Limitations of the PEG Ratio

Pros of PEG

  • Offers investors an extra dimension in comparing stocks: PEG ratios help investors compare stocks that are growing at different rates.
  • Low PEG ratio stocks may yield faster declining P/E ratios: A reasonably high P/E stock may not look atractive right now, but if the PEG is low, and the company achieves growth expectations, the future P/E may look quite affordable using the current stock price.
  • More meaningful than P/E ratio: A PEG ratio gives you a better understanding of a company's potential future value.

Pitfalls & Limitations of PEG

  • Earnings might not continue to grow at the same rate: The PEG ratio assumes that earnings growth will remain constant for the foreseeable future. If there's a hiccup in the growth rate, a previous PEG measure may prove to be inadequate.
  • Not meaningful for low growth stocks: While a PEG ratio may be useful in assessing stocks with higher growth rates, those with low growth do not at all fit well into this measure. For example, a stock with stable earnings and a P/E of 4x but just 1% growth will yield a relatively high PEG of 4x, despite that most investors would perceive a P/E of 4x to be highly undervalued and attractive.
  • Growing companies can be more volatile: Companies that are growing rapidly are often more likely to miss investor expectations or stumble.
  • Does not replace a deeper analysis: No single metric, regardless of whether it's P/E, PEG, P/B or other, can replace thoughtful and detailed company analysis. There may be key insights found in assessing a company's financial statements, leadership, and projections that wouldn't ever be reflected in a valuation metric.

PEG Ratio Interpretation For Investors

PEG ratios can be used to better understand whether a company is appropriately priced, underpriced, or overpriced relative to its future earnings and growth. Calculating a stock's PEG ratio can also be helpful in order to compare it to other companies in the same industry.

P/E ratios can be limiting in assessing the relative performance of a stock to competitors with different growth rates. The PEG ratio takes companies' different growth rates into account so that investors can better understand a stock's price relative to its potential for future growth. This helps investors find stocks that may be more likely to increase in value in the future.

Tip: As a quick reference point, traditionally many investors have used a PEG benchmark level of 1.0 to help them decide whether a stock is overvalued or undervalued. However, in truth not all stocks with PEG < 1.0 are overvalued, and not all stockes with PEG <1.0 are undervalued.

Bottom Line

A PEG ratio is a useful metric investors can use to help assess a company's Price/Earnings ratio relative to expected growth. The use of any single metric, however, cannot replace the benefit of comprehensive analysis of a company's opportunities and risks.

This article was written by

Amanda Reaume profile picture
Amanda Reaume has been writing about retirement, investing, and financial planning for over a decade. She has been published in USAToday, Time.com, Yahoo!Finance, Business Insider, Forbes, and Fox Business. She is a former credit expert at Credit.com and wrote a book about financial planning and investing aimed at millennials.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (4)

Thomas Blankenhorn profile picture
I am sorry to inform you but the bunk formula is simply that, bunk. I exposed this long ago and wish the investing community would wise up and utilize my math-based PEG formula as shown on my profile. The one that got accepted popularly makes no sense except for a very narrow earnings rate growth and just by chance as there is no mathematics involved to support it. Everywhere this should be mentioned. No longer should a formula that does not do what is claimed should be adopted by anyone.
pope.g profile picture
@Thomas Blankenhorn OK I went to read it and repost here for everyone's benefit

"...devised a math based PEG ratio (for a three-year horizon - anything beyond this would be senseless to predict): P/(12E(1+G)^2). I hope S&P's Capital IQ adopts this robust PEG ratio formula as per my communications with them - the presently used formula was produced by a guess that SEEMED like it provided a useful metric but it is broadly a misapplication (the presently used formula is like saying multiplying two numbers is the same as adding them...it may look good enough when the numbers are close to 2 but deviates greatly as you move away from the number "2"). It just so happens that the popularly used PEG ratio formula works is because the growth rate is sometimes around 20%=0.20 and thus 12*(1+0.20)^2=17.3 ~ 20, but values away from this would thus be increasingly erroneous. The presently used formula does not use the growth rate as a percentage but a hundred times the percentage and just luckily appears to make sense for very conforming numbers but there is no mathematical foundation. Had there been a math foundation, the growth rate of zero and negative growth rates would not cause the model to foul up. ..."
lemonCake profile picture
Could you explain the rational behind using a 1x P/E per 1pps of growth exchange rate? It seems like the only thing backing the "PEG=1 is a fair value" heuristic is that Peter Lynch said it in his book from the 90s.
pope.g profile picture
1x PEG doesn’t mean anything. The relationship is not sound. But as said, some investors think that way, so it’s good to know.
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