The PEG Ratio in Stock Valuation

The PEG Ratio (Price/Earnings to Growth), popularized by Peter Lynch in his book, “One Up on Wall Street”, is a measure of valuation that analyzes the relationship between stock price, earnings per share, and the expected growth of the company. The theory is that a fairly-priced stock will have a PEG of 1, while an undervalued stock will be less than 1, an overvalued stock greater than 1.

PEG is preferred by many over the price/earnings ratio (P/E) because PEG factors in projected growth. As most stock investors know, stock ownership is a claim to future earnings of the company and it’s the expectations of these future earnings that drive the stock’s price today. With the PEG ratio, we often see that even a stock with a high P/E may be a good value, provided that it offers high projected earnings growth.

The PEG ratio is calculated by dividing the P/E ratio by the earnings growth rate. For example, if ABC Corporation has a P/E ratio of 30 and a growth rate of 15% per year, its ratio would be 2. What does the “2” mean? As with any ratio, it demonstrates a relationship. The lower the value the less you pay for a unit of future earnings growth.

While a PEG ratio should not be used as the sole component of the stock research process, it can be a powerful tool and complement to the other aspects of the research process. When calculating the ratio, it is important to have access to quality information regarding earnings estimates and the other variables of the calculation.

Like many ratio calculations, PEG is best used when compared with other stocks in the industry. Of course, even if a stock has a very low ratio value, it doesn’t necessarily mean that the stock price will appreciate, but it could be one indication of a good stock investment opportunity. Please note that, the PEG ratio does not work for companies with negative earnings.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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