PEG Ratio: An Important Valuation Tool for Investors

A stock can have a low P/E ratio and still not be attractively valued. The PEG ratio adds earnings growth to the picture.

Researching and valuing stocks takes patience and time, but beginners also need the right valuation tools. The price-to-earnings-to-growth ratio, or PEG ratio, is often considered one of the most valuable metrics.

The PEG ratio adds another layer to the common price-to-earnings (P/E) ratio (discussed in a previous post) by accounting for earnings growth, one of the most important drivers of stock prices. This may help investors value companies with a forward-looking perspective.

The PEG ratio was developed by Mario Farina in 1969 and later popularized by fund manager Peter Lynch to help determine if a stock’s valuation is reasonable based on a company’s expected future earnings growth.

What is the PEG ratio?

The PEG ratio is a valuation metric that compares a stock’s P/E ratio to its expected or current earnings growth rate. Investors often use the PEG ratio to compare companies with different growth rates and quickly screen for reasonably priced stocks. The PEG ratio, because it accounts for growth, can offer a more holistic view of a stock’s valuation than the P/E ratio alone.

How to calculate the PEG ratio

The first step in calculating the PEG ratio is to determine the P/E ratio by dividing a stock’s price by earnings per share (EPS). After that, find the company’s EPS growth rate on free investing websites. Then, apply the PEG ratio formula: 

PEG ratio = (Price/EPS) ÷ Annual EPS growth rate

PEG ratio examples

• Forward PEG example: If a stock has a forward P/E ratio of 20 and analysts expect earnings to grow 10% over the next year, the PEG ratio is 2 (20 ÷ 10 = 2).
• Trailing PEG example: If a stock has a trailing P/E ratio of 20 and its earnings grew 20% over the past 12 months, the PEG ratio is 1 (20 ÷ 20 = 1).

The key is to use consistent inputs. A forward P/E ratio based on EPS estimates over the next 12 months should be paired with a forward-looking growth estimate, while a trailing P/E ratio based on EPS results over the past 12 months should be matched with a growth rate from the same period.

What Doeas the PEG Ratio Tell You?

According to Peter Lynch, a company’s P/E ratio should equal its expected growth rate, indicating a fairly valued company and supporting a PEG ratio of 1.0. When a company’s PEG exceeds 1.0, it’s considered overvalued, while a stock with a PEG of less than 1.0 is considered undervalued.

While a low P/E ratio may make a stock look like a good buy, factoring in the company’s growth rate to get the stock’s PEG ratio may tell a different story. The lower the PEG ratio, the more undervalued the stock may be relative to its future earnings expectations. Adding a company’s expected growth to the ratio helps adjust the result for companies with high growth rates and high P/E ratios.

Mark Notes

While the P/E ratio is more commonly used by investors, the PEG ratio improves on it by incorporating earnings growth estimates. This provides a fuller picture of a company’s relative value in the market. 

However, because it relies on earnings estimates, having good estimates is key. A bad forecast or assumption, or naively projecting historical growth rates into the future, can produce unreliable PEG ratios. The PEG ratio depends heavily on uncertain growth assumptions; it should be paired with other valuation tools and deeper fundamental analysis.

This article is for general informational and educational purposes only. It is not intended as financial advice, investment guidance, or a recommendation to buy or sell any security. The content reflects publicly available information and broad market commentary. Readers should conduct their own research and consult a licensed financial professional before making investment decisions.