What is the PEG Ratio?
The PEG ratio is calculated by dividing a stock's price-to-earnings (P/E) ratio by its expected annual earnings growth rate. A stock with a P/E of 30 and projected earnings growth of 15% per year has a PEG of 2.0. Peter Lynch popularized the rule of thumb that a PEG of 1.0 suggests fair value, below 1.0 indicates potential undervaluation, and above 2.0 may signal overvaluation.
Comparing Stocks with Different Growth Rates
The PEG ratio's strength lies in normalizing valuation across companies growing at different speeds. A tech company with a P/E of 40 and 40% growth (PEG = 1.0) may actually be cheaper than a utility with a P/E of 18 and 5% growth (PEG = 3.6). This makes PEG especially useful when comparing stocks across sectors where raw P/E comparisons would be misleading.
Key Considerations
The PEG ratio is only as reliable as the growth estimate it uses. Analyst consensus forecasts can be overly optimistic, particularly for high-growth companies. Always check whether the growth rate is based on historical earnings, forward estimates, or a blend. The PEG ratio also ignores dividends, so for income-paying stocks, the dividend-adjusted PEG (PEGY) provides a more complete picture.