PEG — Growth-Adjusted P/E
Is a P/E of 30x always expensive? What if that company is growing its earnings 30% every year? PEG is what solves this dilemma with numbers.
The PEG formula and idea
The PEG (Price/Earnings-to-Growth) ratio is the P/E ratio divided by the earnings growth rate.
PEG = P/E ÷ annual earnings growth rate (%)
For example, if the P/E is 20x and earnings grow 20% each year, the PEG is 20 ÷ 20 = 1.
The core idea is simple: 'a fast-growing company deserves a high P/E.' Fund manager Peter Lynch is well known for popularizing this concept. He believed that 'for a fairly valued company, the P/E should be similar to the growth rate.' In other words, a company growing 20% is balanced at a P/E of around 20x.
How to interpret PEG
PEG is read roughly like this.
- PEG ≈ 1: viewed as fairly valued relative to growth. - PEG < 1: many view it as relatively attractive since the P/E is low relative to growth (Peter Lynch is known to have preferred below 1). - PEG > 1: viewed as burdensome since the P/E is high even after accounting for growth.
The advantage of PEG is that it lets you view a 'growth stock that looks expensive on P/E alone' more fairly. Even a P/E of 40x has a PEG of 1 if the growth rate is 40%.
This benchmark (1) is not an absolute law but a rule of thumb. The appropriate PEG can change depending on the interest-rate environment or industry.
PEG's biggest weakness: 'growth rate' is an estimate
PEG has a fatal weakness: the 'earnings growth rate' in the denominator is mostly a 'future estimate.'
Future growth rates are estimated differently by each analyst and, in reality, often miss the mark. Yet changing this estimate even slightly makes the PEG value swing greatly. In other words, PEG is a metric that is 'very sensitive to assumptions.'
On top of that, no one knows how long the current high growth will last. Growth generally slows over time. So PEG is best used as a 'reference tool for roughly gauging the growth premium,' and deciding to buy based on this one number is dangerous. This article is a concept explanation, not a recommendation of any specific stock.
Frequently Asked Questions
Q. What time frame is used for the growth rate in PEG?
There's no fixed rule, but commonly the expected average annual earnings growth rate over the next 3 to 5 years is used. That said, past growth rates are sometimes used and the basis differs by provider, so when looking at PEG you must always check 'which growth rate it was calculated with' for a fair comparison.
Q. Is a stock with a low PEG always a good one?
No. A low PEG may result from estimating the future growth rate too high. If that estimate misses, the PEG's appeal vanishes too. Also, PEG can't see the quality of growth (whether it was growth funded by debt, etc.). You need to view it in balance with other metrics.
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