The
PEG ratio (Price/Earnings
To
Growth ratio) is a
valuation metric for determining the relative
tradeoff between the price of a stock, the earnings
generated per share (EPS),
and the company's expected growth.
In
general, the
P/E ratio is higher
for a company with a higher growth rate. Thus using
just the P/E ratio would make highgrowth companies
appear overvalued relative to others. It is assumed
that by dividing the P/E ratio by the earnings
growth rate, the resulting ratio is better for
comparing companies with different growth rates.[1]
The
PEG ratio is considered to be a convenient
approximation. It was popularized by
Peter Lynch, who
wrote in his 1989 book One Up on Wall Street that
"The P/E ratio of any company that's fairly priced
will equal its growth rate", i.e., a fairly valued
company will have its PEG equal to 1.
Basic formula
Price/Earnings (P/E) 
PEG RATIO =
 
Annual EPS Growth 


The
growth rate is expressed as a percentage above 100%,
and should use real growth only, to correct for
inflation. E.G if a
company is growing at Earnings Per Share (EPS) 30% a
year, and has a
P/E of 30, it would
have a PEG of 1.
A
lower ratio is "better" (cheaper) and a higher ratio
is "worse" (expensive).
The
P/E ratio used in the calculation may be projected
or trailing, and the annual growth rate may be the
expected growth rate for the next year or the next
five years.
Examples:
Yahoo! Finance uses
5year expected growth rate and an averaged P/E for
calculating PEG (PEG for IBM is 1.26 on Aug 9, 2008
[1]).
The
NASDAQ website uses the forecast growth rate (based
on the consensus of
professional analysts) and forecast earnings over
the next
12 months. (PEG for IBM is
1.148 on Aug 9, 2008
[2]).
PEG
as an indicator
PEG
is a widely employed indicator of a stock's possible
true value. Similar to PE ratios, a lower PEG means
that the stock is undervalued more. It is favored by
many over the price/earnings ratio because it also
accounts for growth.
The PEG ratio of 1 is
sometimes said to represent a fair tradeoff between
the values of cost and the values of growth,
indicating that a stock is reasonably valued given
the expected growth. A crude analysis suggests that
companies with PEG values between 0 to 1 may provide
higher returns.[2]
The PEG Ratio can also be a negative number, for
example, when earnings are expected to decline. This
may be a bad signal, but not necessarily so. Under
many circumstances a company will not grow earnings
while its free cash flow improves substantially.
Here, as in other cases, analyzing the components of
PEG becomes paramount to a successful investment
strategy.
The PEG ratio is commonly used
and provided by various sources of financial and
stock information. The PEG ratio, despite its wide
use, is only a rule of thumb and has no accepted
underlying mathematical basis. Its specific
mathematical deficiency is explained
here.
The
PEG ratio's validity at extremes in particular (when
used, for example, with lowgrowth companies) is
highly questionable. It is generally only applied to
socalled growth companies (those growing earnings
significantly faster than the market).
When
the PEG is quoted in public sources it may not be
clear whether the earnings used in calculating the
PEG is the past year's EPS or the expected future
year's EPS; it is considered preferable to use the
expected future growth rate.
It also appears that unrealistically high future
growth rates (often as much as 5 years out, reduced
to an annual rate) are sometimes used. The key is
that management's expectations of future growth
rates can be set arbitrarily high; this is a
selfserving ploy where the objectives are to keep
themselves in office and to make the stock
artificially attractive to investors. A prospective
investor would probably be wise to check out the
reasonableness of
the future growth rate by checking to see exactly
how much the most recent quarter's earnings have
grown, as a percentage, over the same quarter one
year ago. Dividing this number into the future P/E
ratio can give a decidedly different and perhaps a
more realistic PEG ratio.
Advantages
OF THE PEG RATIO
Investors
may prefer the PEG ratio because it explicitly puts
a value on the expected growth in earnings of a
company. The PEG ratio can offer a suggestion of
whether a company's high
P/E ratio reflects
an excessively high stock price or is a reflection
of promising growth prospects for the company.
Disadvantages OF THE PEG RATIO
The PEG ratio is less
appropriate for measuring companies without high
growth. Large, wellestablished companies, for
instance, may offer dependable
dividend income,
but little opportunity for growth.
A company's growth rate is
an estimate. It is subject to the limitations of
projecting future events. Future growth of a company
can change due to any number of factors: market
conditions, expansion setbacks, and hype of
investors. Also, the convention that "PEG=1" is
appropriate is somewhat arbitrary and considered a
ruleofthumb metric.
The simplicity and
convenience of calculating PEG leaves out several
important variables. First, the absolute company
growth rate used in the PEG does not account for the
overall growth rate of the economy, and hence an
investor must compare a stock's PEG to average PEG's
across its industry and the entire economy to get
any accurate sense of how competitive a stock is for
investment. A low (attractive) PEG in times of high
growth in the entire economy may not be particularly
impressive when compared to other stocks, and vice
versa for high PEG's in periods of slow growth or
recession.
In addition, company growth
rates that are much higher than the economy's growth
rate are unstable and vulnerable to any problems the
company may face that would prevent it from keeping
its current rate. Therefore, a higherPEG stock with
a steady, sustainable growth rate (compared to the
economy's growth) can often be a more attractive
investment than a lowPEG stock that may happen to
just be on a shortterm growth "streak". A sustained
higherthaneconomy growth rate over the years
usually indicates a highly profitable company, but
can also indicate a scam, especially if the growth
is a flat percentage no matter how the rest of the
economy fluctuates (as was the case for several
years for returns in
Bernie Madoff's Ponzi scheme).
Finally, the volatility of
highly speculative and risky stocks,
which have low price/earnings ratios due to their
very low price, is also not corrected for in PEG
calculations. These stocks may have low PEG's due to
a very low shortterm (~1 year) PE ratio (e.g. 100%
growth rate from $1 to $2 /stock) that does not
indicate any guarantee of maintaining future growth
or even solvency.
References
and links
^ Easton,
Peter D. (January 2002),
Does The Peg Ratio Rank Stocks According To The
Market's Expected Rate Of Return On Equity Capital?,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301837 [dead
link]
^ Khattab, Joseph
(April 6, 2006),
How Useful Is the PEG Ratio?,
The Motley Fool,
http://www.fool.com/investing/value/2006/04/06/howusefulisthepegratio.aspx,
retrieved November 21, 2010
External links
Investopedia  PEG Ratio
