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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.
| Company | P/E ratio | Earnings Growth | PEG |
|---|---|---|---|
| Company A (Slow growth) | 15 | 5% | 15 ÷ 5 = 3.0 |
| Company B (Fast growth) | 30 | 20% | 30 ÷ 20 = 1.5 |
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. Combine PEG with other stock fundamentals for a complete analysis.
This makes the difference between looking at price and understanding value.
Frequently Asked Questions
Who came up with the PEG ratio? The PEG ratio was popularised by Peter Lynch during his tenure running the Fidelity Magellan Fund, where he argued that a fairly priced growth company should trade at a PEG of around 1.0. Lynch used it as a quick sanity check against the market's tendency to either overpay for popular growth names or ignore fast-growing mid-caps. The rule of thumb has stuck around for decades because it is simple to apply and easy to remember.
What is the difference between trailing and forward PEG? Trailing PEG divides the current P/E by the past growth rate, usually averaged over three to five years of actual reported earnings. Forward PEG uses analyst estimates of future earnings growth, which makes the ratio more responsive to expectations but also more speculative. Trailing is harder to game because the numbers already exist, while forward numbers can shift dramatically whenever analysts revise their forecasts.
Can a PEG ratio be negative, and what does that mean? Yes, a PEG turns negative whenever earnings growth is negative, which happens when profits are shrinking compared with the prior period. The resulting number is mathematically valid but practically useless because the formula is designed for growing companies. In these situations investors usually fall back to other tools like price-to-sales, price-to-book, or a cycle-adjusted earnings measure.
What is the PEGY ratio and how does it differ from PEG? PEGY is a variant, also attributed to Peter Lynch, that divides the P/E by the sum of the earnings growth rate and the dividend yield. The idea is that total shareholder return comes from both growth and dividends, so ignoring the yield penalises mature companies that pay out a meaningful part of their earnings. PEGY tends to make high-yielding, moderate-growth stocks look more attractive than the classic PEG does.