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What is the PEG Ratio?

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The Daily Ledger · Markets

At 35 times profit the shares look dear, but with growth forecast at 30% a year the PEG ratio sits near 1.2, and that is what the bulls are pointing to.

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Overview

The PEG ratio is a company's P/E divided by the rate at which its profit is expected to grow each year. The P/E is the share price divided by one year of profit per share, and the growth rate goes in as a plain number, so 10% counts as 10. Take a company with an $80 share and $4 of profit per share. Its P/E is 20, which is $80 divided by $4. Analysts expect its profit to grow 10% a year, so its PEG is 20 divided by 10, which is 2. A second company has a P/E of 30 and expected growth of 30% a year, so its PEG is 30 divided by 30, which is 1. The second company costs more years of profit, but less per point of expected growth. The growth figure is a forecast, so the PEG is only as good as that forecast.
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Overview

The PEG ratio is a stock's P/E divided by how fast its profit is supposed to grow each year. P/E means share price over a year of per-share profit, so it's a price tag written in years. For the PEG, the growth goes in as a bare number: 15% a year is just 15. One stock has a P/E of 45, meaning it costs 45 years of profit, and is expected to grow 15% a year. Its PEG is 45 over 15, which comes to 3. Another has a P/E of 21, so 21 years of profit, and is expected to grow 14%. Its PEG is 21 over 14, which comes to 1.5. The one that looked pricey and the one that looked cheap just swapped places. That growth figure is somebody's forecast, though, so hold the PEG loosely. 😎

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Detail

The PEG ratio is a company's P/E divided by the rate at which its profit is expected to grow each year. The P/E is the share price divided by one year of profit per share, so it counts how many years of profit the price equals. In the PEG, the growth rate goes in as a plain number, so 25% counts as 25. Company A has a P/E of 40 and expected growth of 25% a year, so its PEG is 40 divided by 25, which is 1.6. Company B has a P/E of 14 and expected growth of 4%, so its PEG is 14 divided by 4, which is 3.5. On P/E alone B looks cheaper, at 14 years of profit against 40. Per point of expected growth, A is cheaper. That is the job of the ratio: the same P/E can mean a dear stock or one expected to grow into its price, and the PEG separates the two. The growth number is usually analysts' estimate of yearly profit growth, and it is a forecast. If A's growth comes in at 12% rather than 25%, its PEG is 40 divided by 12, which is 3.3, and the comparison flips. A common rule of thumb puts the line around 1, with lower read as cheap for the growth and higher as dear for it. A low PEG means less price per point of expected growth, nothing more; built on a hopeful forecast, it is no bargain. There is no PEG for a company with no profit, since it has no P/E, or for one whose profit is expected to shrink. The ratio also works badly for steady companies. A P/E of 10 with 2% growth gives a PEG of 5, which reads as dear even though 10 years of profit is a low price. The PEG is built for growth companies, and the growth in it is always somebody's guess.
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Detail

The PEG ratio is a stock's P/E divided by how fast its profit is supposed to grow each year. P/E means share price over a year of per-share profit, which makes it a price tag in years. The growth goes into the PEG as a bare number, so 32% a year is 32. Say a stock's P/E is 48, meaning it costs 48 years of profit, and analysts expect 32% growth. Its PEG is 48 over 32, which comes to 1.5. Then the analysts trim the forecast to 16%. Now it's 48 over 16, which comes to 3, and the share price never moved. That's the catch with the PEG: one of the two numbers in the sum is a guess about the future. Investors have a habit of calling 1 the dividing line, cheap-for-the-growth below it and pricey-for-the-growth above. A habit, not a law. And a low PEG only ever means you're paying less per point of growth that someone has predicted; it isn't a buy signal, and a low PEG resting on a rosy forecast is a trap. The ratio also has a blind spot for the slow and steady. A stock with a P/E of 9, so 9 years of profit, growing 3% a year gets a PEG of 9 over 3, which comes to 3, and looks expensive when it's just the wrong tool for that stock. No profit means no P/E and no PEG, and when profit is forecast to shrink, the growth number is negative, so the sum spits out a negative PEG that tells you nothing. The PEG is a P/E that has to show its working. 😎

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Analogy

The PEG ratio is a company's P/E divided by its expected yearly profit growth, where the P/E is the share price divided by one year of profit per share. Choosing between two tutors uses the same division. One charges $45 an hour and the other $25. On last term's record, the $45 tutor lifted a student's grade by 10 points and the $25 tutor by 4. Divide the rate by the points and the $45 tutor costs $4.50 a point, the $25 tutor $6.25. The one that looked dear is cheaper per point gained. The hourly rate is the P/E, what you pay for what you get now. The points are the growth. The rate divided by the points is the PEG. Where the picture breaks: the tutor's 10 points are a record of a term that happened, while a company's growth figure is an estimate of years that have not.
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Analogy

The PEG ratio is a stock's P/E, the share price divided by a year of per-share profit, divided again by how fast that profit is expected to grow. Sponsoring influencers runs on the same sum. A brand pays $2,000 a post to two creators who each have 100,000 followers, so both cost 2 cents a follower. That's the P/E: the price per unit of today's audience, and on it the two look identical. Then add growth. One creator's audience grows 40% a year, the other's 5%. Divide the fee by the growth and the first comes out at $2,000 over 40, which is $50 per point of growth, and the second $2,000 over 5, which is $400. Same price today, eight times the price for where the audience is going. That fee-over-growth number is the PEG, and it's why two stocks with the same P/E can be very different buys. One warning: that 40% might be one viral clip from twelve months ago, and that's the forecast problem. Where it falls short: followers are reach, not profit, and a brand pays per post while an investor pays once for every year to come. 😎
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Formal definition β€” The same term, explained the usual way

The price/earnings-to-growth (PEG) ratio is a valuation multiple calculated by dividing a company's price-to-earnings ratio by the expected annual growth rate of its earnings per share, with the growth rate expressed as a whole number rather than a percentage. It is intended to adjust the P/E for anticipated earnings growth so that companies with differing growth prospects can be compared on a growth-adjusted basis; a PEG near 1 is conventionally read as fairly valued relative to growth, below 1 as inexpensive and above 1 as expensive. The ratio depends on which P/E is used (trailing or forward) and on the source and horizon of the growth estimate, typically a consensus forecast of compound annual EPS growth over three to five years, and it is undefined or uninformative where earnings or expected growth are zero or negative.

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