What is the PEG Ratio?
The PEG ratio divides a stock's P/E ratio by its expected earnings growth rate. A stock with a P/E of 30 and 30% growth has a PEG of 1.0. Popularized by legendary fund manager Peter Lynch, PEG adjusts for the fact that fast-growing companies deserve higher P/E ratios. Generally, PEG below 1.0 suggests undervaluation relative to growth, while above 2.0 suggests overvaluation.
Why PEG Improves on P/E
Company A with P/E 15 and 5% growth (PEG 3.0) looks cheaper than Company B with P/E 30 and 40% growth (PEG 0.75) on P/E alone. But PEG reveals that B offers far more growth per unit of price. High-growth companies often appear expensive on P/E but reasonable on PEG. This makes PEG particularly useful for comparing companies with different growth profiles within the same sector.
Limitations
PEG's biggest weakness is that the growth rate in the denominator is a forecast, not a fact. If projected 30% growth materializes at only 15%, the PEG doubles retroactively. PEG cannot be calculated for companies with zero or negative growth, or those reporting losses. Use PEG as a screening tool for growth stocks, but always validate the growth assumption through analysis of competitive position, addressable market, and management execution history.