PEG Ratio

P/E divided by expected earnings growth rate; values <1 may indicate undervaluation.

The Price/Earnings-to-Growth (PEG) ratio is a valuation metric used to assess whether a stock is reasonably priced relative to its expected earnings growth rate. While the traditional Price-to-Earnings (P/E) ratio tells investors how much they are paying for each dollar of current earnings, it fails to account for how fast those earnings are expected to expand. The PEG ratio solves this by dividing the P/E ratio by the percentage growth rate of the company's earnings. To calculate the PEG ratio, an investor first determines the stock's P/E ratio and then divides it by its expected annual growth rate (typically expressed as a whole number, such as 15 for 15%). The growth rate used can be historical, but investors more commonly use forward-looking consensus estimates from analysts over a three- to five-year horizon. Because it incorporates growth, the PEG ratio is particularly popular for evaluating fast-growing technology and growth companies that might otherwise look prohibitively expensive on a standard P/E basis. In general, a PEG ratio of 1.0 is considered to represent fair value, suggesting that the stock's pricing is in perfect harmony with its expected growth. A PEG ratio below 1.0 is often interpreted as a sign of undervaluation, indicating the market is underpricing the company's growth potential. Conversely, a PEG ratio above 1.0 suggests the stock may be overvalued. However, investors must be cautious: the ratio is highly sensitive to the growth estimate used, and overly optimistic analyst projections can make an expensive stock look deceptively cheap.

Company A has a P/E ratio of 30x and its earnings are projected to grow at 15% per year over the next five years. Its PEG ratio is calculated as 30 / 15 = 2.0. Meanwhile, Company B has a higher P/E ratio of 40x, but its earnings are projected to grow at 50% per year. Its PEG ratio is calculated as 40 / 50 = 0.8. Despite having a higher P/E ratio, Company B is considered more attractively valued on a growth-adjusted basis because its PEG ratio is below 1.0.