Peg ratio

What Is Peg Ratio?

The Peg ratio, or Price/Earnings to Growth ratio, is a widely used stock valuation metric within the broader field of investment analysis. It serves to evaluate a company's stock price relative to its earnings per share (EPS) and expected earnings growth rate. The Peg ratio aims to provide a more nuanced perspective than the traditional price-to-earnings ratio by factoring in a company's projected growth. This makes it particularly relevant for assessing growth stocks, where high P/E ratios might otherwise suggest overvaluation.

History and Origin

The Peg ratio was initially developed by Mario Farina, who introduced it in his 1969 book, A Beginner's Guide To Successful Investing In The Stock Market. It was later popularized by the legendary investor and former manager of Fidelity Magellan Fund, Peter Lynch. Lynch famously asserted in his 1989 book, One Up on Wall Street, that for a fairly valued company, its P/E ratio should approximate its growth rate, suggesting a Peg ratio of 1.0. This concept helped investors integrate future growth prospects into their stock analysis.¹⁶, ¹⁷, ¹⁸

Key Takeaways

• The Peg ratio is a valuation metric that adjusts the price-to-earnings ratio for expected earnings growth.
• A Peg ratio of 1.0 is often considered a benchmark for a fairly valued stock, according to Peter Lynch.
• A ratio below 1.0 may suggest a stock is undervalued relative to its growth, while a ratio above 1.0 may indicate overvaluation.
• It is most useful for comparing growth companies within the same industry.
• The accuracy of the Peg ratio heavily relies on reliable future earnings growth forecasts.

Formula and Calculation

The Peg ratio is calculated by dividing a stock's price-to-earnings (P/E) ratio by its projected annual earnings growth rate. The growth rate is typically expressed as a whole number (e.g., 20 for 20% growth).

For example, if a company has a P/E ratio of 25 and an expected annual earnings growth rate of 20%, its Peg ratio would be:

Interpreting the Peg Ratio

Interpreting the Peg ratio involves comparing it to a benchmark, most commonly 1.0. A Peg ratio equal to 1.0 suggests that a stock's price is "fairly valued" relative to its earnings growth potential. A Peg ratio significantly below 1.0 (e.g., 0.5) is often seen as a sign that the stock may be "undervalued," implying that investors are paying less for each unit of earnings growth. Conversely, a Peg ratio significantly above 1.0 (e.g., 2.0) could indicate an "overvalued" stock, where the price might have outpaced its growth prospects. It is important to consider that the conventional "PEG=1" is a rule-of-thumb metric and its suitability can vary by industry and company characteristics.¹⁵

Hypothetical Example

Consider two hypothetical companies, Company A and Company B, operating in the same industry.

• Company A:

  • Current Stock Price: $50
  • Earnings Per Share (EPS): $2.50
  • Expected Annual EPS Growth Rate: 15%
  • P/E Ratio: $50 / $2.50 = 20
  • Peg Ratio: 20 / 15 = 1.33

• Company B:

  • Current Stock Price: $75
  • Earnings Per Share (EPS): $2.50
  • Expected Annual EPS Growth Rate: 30%
  • P/E Ratio: $75 / $2.50 = 30
  • Peg Ratio: 30 / 30 = 1.00

In this example, Company A has a higher Peg ratio (1.33) than Company B (1.00). While Company B has a higher P/E ratio, its Peg ratio suggests it is fairly valued relative to its much higher expected growth. This demonstrates how the Peg ratio can offer a different perspective compared to simply looking at the P/E ratio, helping to identify potentially more attractive investment opportunities among growth companies.

Practical Applications

The Peg ratio is a valuable tool for investors, particularly those focused on growth investing, as it helps to identify companies that may be growing quickly but are not yet fully priced by the market.¹⁴ It is frequently used in equity research and portfolio management to compare companies within the same sector, where growth rates might be more comparable. For instance, an analyst might use the Peg ratio to screen for stocks that offer a favorable trade-off between current valuation and future earnings potential. Professionals often combine the Peg ratio with other valuation methods, such as discounted cash flow analysis, to form a more comprehensive view of a company's intrinsic value.¹³

Limitations and Criticisms

Despite its popularity, the Peg ratio has several limitations. One significant drawback is its heavy reliance on future earnings growth forecasts, which are inherently uncertain and subject to change.¹² Analysts' projections can be inaccurate, and a company's actual growth may deviate significantly from estimates due to market conditions, competitive pressures, or internal challenges.¹¹

Critics also point out that the Peg ratio does not account for factors such as a company's return on equity (ROE), debt levels, cash flow, or the quality of management, all of which are crucial in a comprehensive valuation.⁹, ¹⁰ It is also less appropriate for valuing companies without high growth, such as mature companies that may offer dependable dividend income but limited growth opportunities.⁸ Furthermore, some academic studies have highlighted issues with the Peg ratio's theoretical foundation and its units of measure, suggesting it may not always be a reliable indicator for all firms.⁶, ⁷ As Joel Greenblatt notes, focusing solely on a simple ratio without considering deeper fundamentals like earnings yield and return on capital can be misleading.⁵

Peg Ratio vs. Price-to-Earnings (P/E) Ratio

The Peg ratio is often considered an extension or refinement of the price-to-earnings ratio (P/E ratio). The P/E ratio measures how much investors are willing to pay for each dollar of a company's current or trailing earnings. While useful, the P/E ratio does not explicitly account for a company's growth prospects. A high P/E ratio might suggest an overvalued stock, but for a rapidly growing company, that high P/E could be justified by strong future earnings. This is where the Peg ratio provides added context. By dividing the P/E ratio by the earnings growth rate, the Peg ratio attempts to level the playing field, making it easier to compare companies with different growth rates. The core difference is that the P/E ratio is a static snapshot of current valuation relative to earnings, while the Peg ratio introduces a dynamic element by incorporating projected growth into the valuation equation.², ³, ⁴

FAQs

What does a Peg ratio of less than 1 mean?
A Peg ratio of less than 1 generally suggests that a stock might be undervalued, implying that its price is low relative to its expected future earnings growth. It could signal a potential buying opportunity for investors seeking growth at a reasonable price.

Is the Peg ratio useful for all types of companies?
No, the Peg ratio is primarily useful for evaluating growth stocks or companies with positive earnings and expected future growth. It is less applicable for mature companies with stable or declining earnings, or for companies that do not pay dividends, as it doesn't adequately capture their value.¹

Can the Peg ratio be negative?
Yes, a Peg ratio can be negative if a company has negative earnings (resulting in a negative P/E ratio) or if its expected earnings growth rate is negative. A negative Peg ratio typically indicates that the company is struggling financially or is expected to have declining earnings, which is generally not a favorable sign for investors.