PEG Ratio

A high P/E can be justified if a company is growing fast. The PEG ratio tries to capture that trade off in one number by dividing the P/E ratio by the expected earnings growth rate. Popularised by investor Peter Lynch in his 1989 book "One Up on Wall Street", the PEG ratio is a quick way to compare companies with different growth rates. It is useful as a screening tool, but it relies heavily on growth forecasts and ignores risk and the length of growth.

The formula#

PEG = P/E ratio / expected annual EPS growth rate (in percent)

Growth is entered as a whole number: 20% growth becomes 20.

Interpreting PEG#

These thresholds are rules of thumb, not laws.

Worked example#

Variations#

• Trailing vs forward: use forward P/E with forward growth to match time periods.
• PEGY ratio: P/E divided by (growth + dividend yield), crediting dividend paying companies for income.
• Different growth horizons: analysts typically use 3 to 5 year expected EPS growth.

Limits of the PEG ratio#

1. Growth estimates are uncertain. Analysts' long term growth forecasts have historically been too optimistic on average, according to academic studies of analyst forecasts.
2. Duration of growth is ignored. A company growing 20% for 2 years is worth far less than one growing 20% for 10 years, yet both have the same PEG.
3. Risk is ignored. A riskier company deserves a lower multiple at the same growth.
4. Quality of growth: growth from acquisitions or buybacks differs from organic growth.
5. Low or negative growth makes the ratio meaningless or extreme.
6. Interest rates: the "fair" PEG changes as rates change.

PEG in practice#

• Screening: find growth companies that do not look overpriced relative to expectations.
• Comparisons within an industry, where risk and growth duration are similar. See Comparable Companies and Precedent Transactions.
• Sanity checks: a PEG of 4 or 5 should prompt questions about what the market is assuming.

For more rigorous analysis, a discounted cash flow model makes growth duration and risk explicit. See DCF Valuation.

Common mistakes#

• Using one year growth for a multi year valuation.
• Comparing PEGs across very different industries.
• Trusting long term analyst growth estimates without checking their realism.

Checking the growth input#

Before trusting a PEG, compare the growth estimate with the company's own history, its industry's growth and its guidance. If a company grew earnings 8% a year for a decade but the PEG uses 25% future growth, ask what has changed. Revenue growth, margin trends and reinvestment rates should all support the forecast. See Guidance and Earnings Revisions.

Frequently asked questions#

What is the PEG ratio?#

The P/E ratio divided by the expected annual earnings growth rate, used to compare valuation relative to growth.

What is a good PEG ratio?#

A PEG around 1 is often considered fair and below 1 potentially cheap, but these are rules of thumb that depend on risk and the reliability of growth estimates.

What are the weaknesses of the PEG ratio?#

It depends on uncertain growth forecasts, ignores how long growth lasts and ignores differences in risk.

Next, learn multiples that account for debt in EV/EBITDA and EV/Sales.