The PEG ratio

In simple terms

A high P/E is not necessarily expensive if profits are growing fast. The PEG ratio is a shortcut that tries to adjust P/E for growth:

A company with a P/E of 30 and expected growth of 30% a year has a PEG of 1. One with a P/E of 12 and growth of 6% a year has a PEG of 2. On this measure, the faster grower looks cheaper for its growth, despite its higher P/E.

A popular rule of thumb says a PEG below 1 means a share is cheap and above 1 means it is expensive. That rule is far less reliable than it sounds.

The growth figure is fragile

The growth rate in a PEG is a forecast, usually for the next few years. Forecasts are uncertain, and the PEG is very sensitive to them.

Use multi-year growth that you can defend, check it against the company's history, as the growth lesson explains, and test a lower figure.

What PEG leaves out

How long growth lasts. A company growing 25% for two years and one growing 25% for ten years have the same PEG, but the second is worth far more.

Returns on capital. Growth that needs heavy investment at low returns is worth less than growth that needs little investment. The incremental returns lesson explains why. PEG treats both the same.

Risk. A volatile, indebted company and a steady, cash-rich one with the same P/E and growth get the same PEG.

Interest rates. When interest rates and required returns are high, investors pay less for future growth. A PEG of 1 means different things at different rates.

Low-growth companies. For a company growing 3% a year, any reasonable P/E gives a high PEG, even if the share is good value because of a high dividend or a strong balance sheet. Dividing by a small number exaggerates the ratio. And for a company with zero or negative growth, PEG cannot be used at all.

A better way to think about it

PEG is a crude attempt to answer a real question: how much growth is this price already assuming? A more careful way to answer it is a reverse DCF, which works out the growth implied by the current price and lets you judge whether that growth is likely, taking into account how long it must last and how much investment it needs.

Used modestly, PEG can help you sort a list of companies: a share with a P/E of 40 and growth of 8% is clearly asking a lot. But it should prompt questions, not decide answers.

Why it matters

PEG is widely quoted in market commentary and investment marketing, often with a confident "below 1 means cheap". Knowing its hidden assumptions protects you from paying high prices for growth forecasts that may not come true, and from dismissing slow-growing companies that may be good value for other reasons.

Limitations

PEG combines a ratio based on today's profit with a forecast of tomorrow's growth, over an unspecified period. Different sources use different P/Es (trailing or forward) and different growth periods, so PEGs from different places are often not comparable. It is a rule of thumb, not a valuation method.

Common mistakes

• Treating PEG below 1 as proof of value.
• Using a single optimistic growth forecast without testing lower ones.
• Mixing forward P/E with long-term growth from a different source.
• Applying PEG to slow-growing or loss-making companies.

Try it yourself

1. Choose a listed company with a high P/E.
2. Calculate its five-year historical EPS growth rate, and find a forecast growth rate in a broker report or news article.
3. Calculate the PEG using each growth rate.
4. Work out what growth rate would give a PEG of 1, and decide whether that growth is realistic given the company's history.