What Is the PEG Ratio?
Price-to-Earnings-to-Growth (PEG) Ratio Explained
The price-to-earnings-to-growth, or PEG, ratio is a modified version of the price-to-earnings ratio (P/E), which is a popular way for investors to measure the relative valuation of two stocks. Less well-known than its fundamental cousins, this ratio can give you a more informed view of a stock's actual value, and thus the potential for earning, once you know how to use and interpret the results correctly.
What Is the PEG Ratio?
The PEG ratio is a form of the P/E ratio, which tells investors how much Wall Street is willing to pay for every $1 in company earnings. In general, a lower P/E is considered better because it suggests that the price is backed up by fundamentals, rather than speculation.
One of the limitations of P/E is that it doesn’t factor in growth in underlying earnings. Back when Sam Walton first began opening Walmart stores throughout the United States, Walmart's P/E at the time failed to account for the growth potential in the investments in expansion. If an investor were to acknowledge growth, they would've realized that Walmart was one of the cheapest stocks available on a value basis. The future cash flows more than justified the stock's level of valuation.
To make up for this shortcoming in P/E, investors began using the price-to-earnings-to-growth ratio, or PEG.
How to Calculate the PEG Ratio
To calculate the PEG, an investor must first calculate the P/E. Let's say stock for the hypothetical company ABC is trading for $20 with earnings per share (EPS) of $1.50. To calculate that stock's P/E, simply divide the price of $20 by the EPS of $1.50, giving you a P/E of 13.33.
Though not necessary for calculating the PEG, you can also invert this P/E ratio to calculate something known as the earnings yield. For this example, that would give you an earnings yield of 0.075, or 7.5% (1 ÷ 13.33 = 0.075). This figure makes it easier to compare shares of a company to investments like bonds or real estate.
Once you have the P/E, you simply divide that by the growth in earnings per share to arrive at the PEG ratio.
PEG = Price to Earnings Ratio / (Projected or Actual) Earnings Growth
Like P/E, a lower PEG is generally considered preferable to a higher PEG.
Let's stick with the ABC example. You know that conservative estimates expect company ABC to grow 3% in the next year. Now, compare ABC stock to the stock for company XYZ, which trades at $60 per share with an EPS of $4 and expected annual growth of 5%. Which stock is cheaper? By calculating the PEG ratio, you can find out.
Company ABC's PEG would be calculated like this:
- $20 stock price divided by $1.50 EPS gives you a P/E of 13.33
- P/E of 13.33 divided by 3% growth gives you a PEG of 4.44
Compare that to Company XYZ's PEG:
- $60 stock price divided by $4 EPS gives you a P/E of 15
- P/E of 15 divided by 5% growth gives you a PEG of 3
In this case, XYZ appears cheaper at $60 per share than ABC does at $20 per share, despite having a higher P/E ratio.
For PEG calculations, the growth figure is kept as a whole number, rather than converted to decimal form.
Dividend-Adjusted PEG Ratio
A simple PEG ratio works best for companies that don't offer dividends. However, many stocks do come with dividends, especially when it comes to major corporations and blue-chip stocks. Those dividends cut into the company's true EPS.
If the stock you're watching offers a dividend, you might prefer to use a dividend-adjusted PEG ratio. Calculating it requires just a slight adjustment to the standard PEG ratio formula. Instead of simply dividing the P/E by the expected earnings growth, you first add together the expected earnings growth and dividend yield. You then divide the P/E by that figure.
How to Use the PEG Ratio
Using the PEG ratio in conjunction with a stock's P/E can tell a very different story than using P/E alone.
A stock with a very high P/E might be viewed as overvalued and not a good choice. Calculating the PEG ratio on that same stock, assuming it has good growth estimates, can actually yield a lower number, indicating that the stock may still be a good buy.
The opposite holds true as well. If you have a stock with a very low P/E you might logically assume that it is undervalued. However, if the company does not have earnings growth projected to increase substantially, you may get a PEG ratio that is, in fact, high, indicating that you should pass on buying the stock.
Limitations of the PEG Ratio
The biggest danger in using the PEG ratio to find cheap stocks comes from being overly optimistic. Growth estimates are just that—estimates. Using the most conservative figure available helps avoid overpaying for a stock that doesn't deliver on growth expectations. By banking too much on the promise of the future, a stock that would otherwise be worthless might appear to be a great bargain.
When investors as a whole become overly optimistic, this creates a stock market bubble—like the dot-com and housing bubbles that "popped" in 2000 and 2008, respectively. When investors realize that their optimism allowed stock prices to rise too high, those bubbles burst with sudden stock crashes.
As with any analysis, the quality of results changes depending on the input data. For example, a PEG ratio may be less accurate if calculated with historical growth rates, as compared to the ratio if a company has projected higher or upward-trending future growth rates.
What's a Good PEG Ratio?
The baseline number for an overvalued or undervalued PEG ratio varies from industry to industry, but investment theory says that, as a rule of thumb, a PEG of below 1 is optimal. When a PEG ratio equals 1, this means the market's perceived value of the stock is in equilibrium with its anticipated future earnings growth.
If a stock had a P/E ratio of 15, and the company projected its earnings to grow at 15%, for example, this gives it a PEG of 1.
When the PEG exceeds 1, this tells you that the market expects more growth than estimates predict, or that increased demand for a stock has caused it to be overvalued.
A ratio result of less than 1 says that analysts have either set their consensus estimates too low or that the market has underestimated the stock's growth prospects and value.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
Investor.gov. "Price-Earnings (P/E) Ratio." Accessed June 1, 2020.
Nasdaq, Inc. "PEG Ratio vs. the P/E Ratio." Accessed June 1, 2020.
Nasdaq, Inc. "How to Calculate a Dividend Adjusted PEG Ratio." Accessed June 1, 2020.
Bureau of Labor Statistics. "The U.S. Housing Bubble and Bust: Impacts on Employment," Page 2. Accessed June 1, 2020.