PEG Ratio – Stock Valuation Tool

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PEG Ratio - Price Earnings Growth Ratio

The PEG Ratio is a stock valuation tool for investment analysis. Its purpose is to evaluate and the trade off between the price of a stock, the earnings per share, and the company’s expected growth rate.

Peter Lynch, when managing the ultra successful Fidelity Magellan mutual fund, popularized the ratio. He writes in his book “One Up On Wall Street”: “The P/E ratio of any company that’s fairly priced will equal its growth rate.”

Calculate PEG Ratio

The PEG Ratio calculation is:

(Price/Earnings)  /  Expected Growth Rate  = PEG Ratio

How to Use the PEG Ratio

Lynch recommended that you first find attractive companies, and then use the PEG ratio as a tool to evaluate and compare the different companies.

In general, companies with high ratio (over 1.0) would be more overvalued than companies with a low ratio (under 1.0).

Examples: Company A is selling for \$30, has earnings of  \$2, and an expected growth rate of 15%. PEG Ratio = 1

Company B is selling for \$60, has earnings of \$4, and an expected growth rate of 20%.  PEG Ratio = 0.75

Company C is selling for \$45, has earnings of \$1, and an expected growth rate of 30%.  PEG Ratio = 1.5

The Price Earnings Growth Ratio would indicate company B has the most undervalued price. Company C is the fastest grower but the most overvalued price. Company A is expected to grow the slowest and is fairly valued.

The main value of the PEG ratio is that it is an easy calculation and assigns a relative value to expected future earnings growth of a company. In other words, it allows the analyst to compare the valuation of companies with different growth rates. It is a more thorough picture of valuation than the P/E ratio alone.

The PEG ratio is rule of thumb, or an approximation; not a mathematical certainty by any means. In addition, the formula is only as good as its inputs.

The greatest chance for inaccurate input would be the future growth rate assumption. Anytime an analyst makes assumptions about the future it can be incorrect.

The ratio has limitations in measuring companies with low growth. As an example, a mature company may have good earnings and a solid dividend, but a slow growth rate. Obviously, a company growing earnings at 1% is probably not going to sell at a P/E ratio of 1.

Stock Valuation Tools

The PEG Ratio should be one of the tools in your valuation tool box. Here are some other valuation tools to consider:

Different Types of Cash Flow For Investment Analysis

ROEV – Return on Enterprise Value <= My favorite!

Use stock valuation tools such as the PEG Ratio to evaluate and compare companies. The ratio provides insight into the trade off between the price of the stock, the earnings per share, and company’s expected growth rate!

Written by KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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I’ve never liked the PEG ratio. I don’t think it’s mathematically sound. For example, as growth goes to zero PEG goes to infinity. But zero growth companies aren’t inherently overvalued. Their correct valuation is just the time value of their income stream less any risk deduction or time limit you care to add.

That sort of bad behavior in limit conditions is a sign of mathematical voodoo.

KenFaulkenberry

There are definitely some limitations to the PEG ratio, but calling it mathematical voodoo is a little strong. Peter Lynch used it successfully for many years. I tried to emphasize in the post that the PEG ratio is just one of many tools in valuation tool box. As with any tool, you must understand how to use it properly. It does give the analyst a way to compare the valuations of growth companies. You are entirely correct that it not for use with no or slow growth companies. Thanks for adding to the conversation!

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