PEG Ratio: What It Is, How to Calculate It and When It Misleads

The PEG ratio formula

PEG ratio = (price ÷ earnings per share) ÷ expected annual EPS growth rate × 100

Growth goes in as a whole number: a company expected to grow earnings 20% a year uses 20, not 0.20. Northfield Tools, the fictional industrial company in these guides, trades at $60 with $3.00 of trailing earnings per share, a P/E of 20, and analysts expect EPS to grow 20% a year over the next few years. Its PEG is 20 ÷ 20 = 1.0. Use the forward P/E of 16.7 instead and the PEG is 0.83, which illustrates the first thing to know: the result depends on which P/E and which growth rate you choose, and the forward vs trailing P/E article explains why the two multiples differ.

The convention, popularised by the fund manager Peter Lynch, is that a PEG around 1 marks a fairly priced growth stock, below 1 a cheap one and above 2 an expensive one. It is a rule of thumb, and like most rules of thumb it works in the middle of the range it was drawn from and fails outside it.

Worked example: three companies (illustrative)

Read literally, the utility is the most expensive stock on the table and the software company is only a little pricey. Few investors would accept either conclusion. A reliable 3% grower at 15 times earnings offers a 6.7% earnings yield that grows with inflation, which is not expensive at all; and a 50× multiple requires 35% growth to be sustained for years, which is a strong claim about the future, not a modest one. The PEG is doing something wrong at both ends, and the next section shows what.

Why a PEG of 1 is not the same as fair

The P/E a company deserves depends on its growth, the return investors require and how long the growth lasts, and the relationship is not a straight line. For a business whose earnings grow at g forever and that pays them all out, the justified P/E is 1 ÷ (r − g), where r is the required return. At r = 9%:

A fairly priced slow grower has a PEG of 5 or more, so PEG calls every stable business expensive. At the other end, growth of 20% or 35% cannot last forever, so the perpetual formula does not apply at all; what matters is how many years the growth continues before fading, and PEG has no term for that. Two companies both growing 30% next year, one for two more years and one for ten, get the same PEG and deserve very different multiples. Nor does PEG know about risk: a 20% grower in a cyclical, leveraged business and a 20% grower with recurring revenue and no debt get the same score. The good P/E ratio article builds the fair multiple from these pieces instead of assuming it scales with growth.

Which growth rate to use

Most published PEGs use the consensus estimate of annual EPS growth over the next three to five years. That figure is an analyst average that few of its authors would defend to the decimal, and it tends to be highest exactly when the stock has already done well. Three cautions:

• Use the same basis as the P/E. A forward P/E on adjusted earnings with growth measured from GAAP earnings mixes two definitions.
• Check the record. A 25% forecast for a company that has grown 8% a year for a decade is a claim that something changed. Know what.
• Watch the revisions. A PEG built on estimates being cut each quarter is less reliable than the same number on estimates being raised; the earnings surprise article covers how revisions move prices.

The better test: what growth does the price require?

PEG tries to answer one question: is the price reasonable for the growth? The direct way to answer it is to start from the price and solve for the growth it requires over a realistic horizon, then ask whether the business can deliver it. Northfield at 20× earnings, with a 9% required return and a P/E of 18 at the end of ten years, needs about 10% earnings growth a year to justify its price. That is a number you can test against its record, its industry and its margins, and it does not depend on a rule of thumb. The implied growth rate article explains the method and the stock valuation guide places it among the others; VALYSTR's Belief Gap runs it on any listed company's own filed numbers next to the consensus forecast, which is the comparison PEG was trying to make all along.

Using PEG sensibly

PEG is still a useful first filter if its limits are respected. Use it only among companies with similar growth rates, similar risk and similar growth duration, which usually means within an industry. Treat a PEG below 1 as a reason to look, not a reason to buy, and a high PEG on a steady business as no verdict at all. Then do the real work: check where the growth comes from, how long it can last, and what the price already assumes.

One more habit keeps the ratio honest: compute it twice, once on the one-year growth forecast and once on the longer consensus, and notice when the two disagree. A company whose PEG looks attractive only on the five-year number is being valued on growth that nobody has seen yet, and the burden of proof sits with the forecast, not with the price.