PEG Ratio
Ratios
Overview
The PEG ratio (price/earnings-to-growth) is a valuation metric that adjusts the P/E ratio by the company's earnings growth. It helps compare companies with different growth profiles by showing how much investors pay for each unit of earnings growth.
Alternative Names: Price/Earnings to Growth, P/E to Growth, PEG
Formula
PEG = P/E ÷ 1-Year EPS Growth
Where:
- P/E = Price-to-Earnings ratio
- 1-Year EPS Growth = For trailing-twelve-month (TTM) records, this is measured as TTM EPS in the last reported quarter versus TTM EPS in the same quarter a year earlier
Calculation Example
Let's calculate the PEG ratio for a company to demonstrate the process:
Example Company - Financial Data:
- Current Stock Price: $50
- Earnings Per Share (EPS): $2.50
- 1-Year EPS Growth Rate: 20%
Step 1: Calculate P/E Ratio
P/E Ratio = Stock Price ÷ EPS
= $50 ÷ $2.50
= 20
Step 2: Calculate PEG Ratio
PEG = P/E ÷ 1-Year EPS Growth
= 20 ÷ 20
= 1.0
Interpretation: A PEG ratio of 1.0 suggests the stock is priced roughly in line with its growth rate. Investors are paying approximately fair value for each unit of earnings growth.
How to Interpret
As a rule of thumb, understanding PEG ratio values helps investors assess whether a stock's valuation is justified by its growth rate. The ratio normalizes the P/E for growth, enabling comparison across companies with different growth rates.
PEG Ratio Guidelines:
Below 1.0 - Potentially Better Value
A PEG ratio lower than 1.0 can indicate potentially better value, suggesting investors are paying less for each unit of growth. The stock may be undervalued relative to its growth prospects, though it is important to verify that the growth is sustainable and not artificially high.
Around 1.0 - Fair Valuation
A PEG ratio around 1.0 implies a stock is priced roughly in line with its growth rate. This suggests fair valuation where the P/E multiple appropriately reflects the earnings growth rate. Investors are paying approximately market value for the company's growth.
Above 1.0 - Richer Valuation
A PEG ratio higher than 1.0 can indicate a richer valuation, meaning investors are paying a premium for each unit of growth. While this may reflect superior growth quality or competitive advantages, it also carries higher risk if growth expectations are not met.
Negative PEG Ratio: A negative PEG usually results from negative or shrinking EPS (or negative measured growth). It typically signals that PEG is not meaningful for that period and should be interpreted with caution. In such cases, review the underlying earnings trend, one-off items, and whether EPS is cyclically depressed.
Industry Context is Critical: Always compare PEG among peers in the same industry and consider growth quality and cyclicality. PEG is most informative when growth is expected to be sustainable and when earnings are not highly volatile.
Why It Matters
The PEG ratio provides a more complete valuation picture than P/E alone by accounting for growth expectations. It helps investors assess whether they are paying a reasonable price for a company's growth prospects.
Key Insights:
- Growth-Adjusted Valuation: PEG helps normalize the P/E ratio for growth, allowing investors to compare valuation across companies with different growth rates. This provides a fairer comparison than using P/E alone.
- Cross-Company Comparison: Enables meaningful comparison of companies with different growth profiles. A high-growth company with a high P/E may have a lower PEG than a low-growth company with a moderate P/E.
- Value Assessment: Shows how much investors pay for each unit of earnings growth, helping identify whether a stock offers good value relative to its growth potential or is overpriced.
- Comprehensive Analysis Required: PEG is most effective when used together with other indicators such as P/S (price-to-sales), profit margins, and cash flow to build a fuller view of the company's financial health and valuation.
Key Takeaways
- The PEG ratio adjusts the P/E ratio by the company's earnings growth rate
- It is calculated as P/E divided by 1-year EPS growth
- Around 1.0 implies a stock is priced roughly in line with its growth
- Below 1.0 can indicate potentially better value (paying less for growth)
- Above 1.0 can indicate a richer valuation (paying premium for growth)
- Always compare PEG among peers in the same industry
- Consider growth quality and cyclicality when interpreting PEG
- Most informative when growth is expected to be sustainable and earnings are not highly volatile
- Negative PEG results from negative/shrinking EPS and is not meaningful
- Use PEG together with other indicators (P/S, margins, cash flow) for comprehensive analysis
Related Financial Ratios
These related metrics provide additional insights for comprehensive valuation analysis:
Price to Earnings Ratio (P/E)
Measures stock price relative to earnings per share. PEG adjusts this ratio by dividing it by the earnings growth rate to account for growth expectations.
Price to Sales Ratio (P/S)
Compares market capitalization to total revenue. Used alongside PEG to build a fuller view of valuation, especially for companies with volatile or negative earnings.
Earnings Per Share (EPS)
The portion of profit allocated to each share. EPS growth rate is the denominator in the PEG ratio calculation and critical for understanding the company's growth trajectory.