PEG Ratio: The growth hunter's best friend

Discover why that 'expensive stock' could be your best bargain.

Explainer

A stock's Price/Earnings to Growth Ratio (PEG) tells you if a stock is expensive relative to how fast it is actually growing.

In general, a lower PEG suggests a buying opportunity - you are paying less for each unit of growth that you are getting.

How to read PEG numbers

PEG numbers fall into three ranges, with research indicating:

• PEG below 1.0: Potentially undervalued growth (buy opportunity)
• PEG 1.0-2.0: Fair value range
• PEG above 2.0: Possibly overpriced growth

Formula

A PEG ratio is calculated by dividing a stock's P/E ratio by its earnings growth rate.

Example

This example shows two companies where one company has higher earnings growth and thus a lower PEG ratio, while the other has slower growth and a higher PEG ratio.

Surprised? Company B's PEG of 1.5 is much better than Company A's PEG of 3.0. You're paying half as much for each percentage point of growth with Company B.

In our example, Company B (PEG 1.5) sits in the fair value range, while Company A (PEG 3.0) appears overpriced for its growth rate.

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Why PEG beats P/E alone

The reason that PEG is the better indicator is because P/E ratios only show the current price relative to earnings but ignore how fast those earnings are actually growing.

• Growth compounds over time
• A company growing earnings 20% annually doubles its profits in 3.6 years
• One growing 5% takes 14 years

This is why a stock with a high P/E might actually be cheaper than a stock with a low P/E - if you account for growth rates.

When does PEG work best?

PEG is most effective for:

• Growth stocks with consistent earnings increases
• Comparing companies within the same industry or sector
• Stocks with 3-5 year growth track records

Attention points

Always remember that the PEG ratio is not a silver bullet. Limitations to consider:

• Cyclical companies may show misleading growth rates
• Very high growth rates (50%+) are rarely sustainable
• Use historical growth, not analyst projections

The bottom line

PEG ratio answers a critical question: "Am I paying a fair price for this company's growth?"

Before buying any growth stock, always calculate its PEG. You might discover that the 'expensive stock' with a high P/E is actually cheaper per unit of growth than the "bargain" with a low P/E.

This makes the difference between looking at price and understanding value.