PEG Ratio Definition: The PEG ratio is a stock’s price-to-earnings ratio divided by its expected annual growth rate in earnings per share, with the growth rate written as a whole number. A company trading at 20 times earnings with 20% expected growth has a PEG of 1.0. The ratio lets you compare companies that grow at different speeds on a single scale.
What Is the PEG Ratio?
A company with a P/E of 40 is not automatically more expensive than one with a P/E of 15. If the first doubles its profits every three years and the second barely grows, the higher multiple may be the better deal. The PEG ratio puts a number on that judgment.
The idea is usually traced to Mario Farina’s 1969 book on stock investing, but Peter Lynch made it famous. In his 1989 book, the former manager of Fidelity’s Magellan fund argued that a fairly priced company has a P/E ratio roughly equal to its growth rate. A stock below that line, in his view, deserved a closer look.
That rule turned the PEG into a favourite screen for growth-at-a-reasonable-price investors. They want companies that grow fast, but not ones whose price already assumes perfection.
How to Calculate the PEG Ratio
The formula is PEG = P/E ÷ annual EPS growth rate. Most analysts use the expected growth rate over the next three to five years, taken from consensus forecasts of earnings per share. The P/E can be trailing or forward, so check which one a data source uses before comparing numbers.
Imagine two stocks. A software company trades at a forward P/E ratio of 30, and analysts expect earnings to grow 25% a year. Its PEG is 30 ÷ 25 = 1.2. A utility trades at a P/E of only 15, but its earnings grow 5% a year, giving a PEG of 3.0.
On P/E alone, the utility looks half as expensive. Adjusted for growth, the software company is cheaper, because each point of its multiple buys far more future profit. If both companies hit their forecasts for five years, the software firm’s earnings rise about 205% while the utility’s rise about 28%.
Types of PEG Ratio
Trailing PEG uses the reported P/E and the growth rate of past earnings. It rests on known numbers but assumes the past growth rate will continue.
Forward PEG uses the forward P/E and analysts’ expected growth rate. This is the version most screens show, and it carries the full risk of forecast error.
Dividend-adjusted PEG, sometimes called PEGY, adds the dividend yield to the growth rate. A bank with a P/E of 12, 6% growth and a 4% yield has a standard PEG of 2.0 but a PEGY of 1.2, which treats cash paid out as part of the return.
PEG Ratio vs. P/E Ratio
| PEG Ratio | P/E Ratio | |
|---|---|---|
| Formula | P/E ÷ expected EPS growth rate | Share price ÷ EPS |
| Accounts for growth | Yes, directly | No |
| Inputs that need forecasting | Growth rate, and EPS if forward | None if trailing |
| Works for loss-makers or shrinking firms | No | No for losses, yes for shrinking profits |
Why Is the PEG Ratio Important for Traders?
The PEG ratio stops you from dismissing every high-multiple stock as a bubble or buying every low-multiple stock as a bargain. It is most useful when comparing companies in the same industry, where risks and accounting are similar. Among a group of chipmakers, for example, the one with the lowest PEG is the one whose price asks least for each unit of expected growth.
Its weak point is the growth forecast. Analysts’ five-year growth estimates are among the least reliable numbers in finance, and they tend to be highest just as a company’s fastest growth ends. A growth stock with a PEG of 0.8 can turn into one with a PEG of 4 after a single guidance cut, without its price changing at all.
The ratio also ignores risk and the cost of money. A PEG of 1 means one thing when bonds yield 1% and another when they yield 5%, because higher interest rates reduce what investors will pay for distant profits. Treat Lynch’s rule of thumb as a starting point, then test the growth story behind the number.
Key Takeaways
- The PEG ratio divides the P/E ratio by the expected annual growth rate of earnings per share, putting fast and slow growers on one scale.
- A PEG around 1 is the classic marker of fair value, a rule of thumb popularised by Peter Lynch.
- Trailing, forward and dividend-adjusted versions exist, so always check which P/E and growth rate a source uses.
- The ratio is only as good as its growth forecast, and long-term growth estimates are often too optimistic.
- The PEG ignores risk, interest rates and companies with falling or negative earnings, so use it alongside other valuation measures.
What is a good PEG ratio?
A PEG near 1 is often read as fair value, below 1 as cheap and above 2 as expensive. These are rules of thumb, and the right level depends on interest rates, risk and how reliable the growth forecast is.
Why can't I use the PEG ratio for a company with falling earnings?
With zero or negative growth the ratio becomes infinite or negative, so it says nothing useful. For shrinking or cyclical businesses, use other measures such as EV/EBITDA or price-to-book.
Is the PEG ratio better than the P/E ratio?
It adds one piece of information, the growth rate, but it also adds a forecast that can be wrong. Use it alongside the P/E rather than instead of it.
