PEG Ratio: How Much to Pay for Growth

Two hypothetical stocks sit on your watchlist. One trades at 30 times earnings, the other at 20. The first looks expensive. Maybe it is. But if the first company’s earnings grow 15% a year and the second’s grow 20%, the ranking flips, and the P/E on its own can’t show you that.

The PEG ratio adds growth to the sum. It divides the price-to-earnings ratio by the expected annual growth rate of earnings, written as a whole number, so 15% growth goes in as 15.

A lower PEG means you pay less for each point of growth. Some investors treat a PEG around 1 as a fair price, and that is a rough convention with nothing official behind it, so use it as a place to start the comparison. If you need a refresher on the P/E itself, the lesson on price against earnings covers it.

The growth number is a guess

The P/E is a fact. You can read the price off a quote and the earnings off a filing. The growth rate is a forecast, usually built from analyst estimates and management’s earnings guidance, and the PEG is exactly as good as that forecast.

Watch what happens when the forecast misses. Stock B looked cheap at a PEG of 1.0 on 20% expected growth. If its earnings grow 10% instead, the same P/E of 20 divided by 10 gives a PEG of 2.0, no cheaper than Stock A.

So before you rely on a PEG, find out where the growth figure came from and how it has held up. The explainer on where earnings estimates come from goes through how those numbers get built. Then run the PEG on a lower growth rate too, and see whether the stock still looks reasonable if the optimists are wrong by a third.

How many years of growth is in the price

A different way in asks what the price already assumes. Take Stock A at a P/E of 30. Suppose its earnings really do compound at 15% a year for five years and the share price never moves.

That is the bet you’re making when you buy at 30. The company has to keep growing at the forecast rate for five full years just to reach a multiple that a slower, steadier business might trade on today. If growth slows to 8% a year instead, earnings rise only by a factor of about 1.47 over the five years, and the P/E on today’s price is still about 20 at the end, so the stock needs either more years of growth or a buyer later who is willing to keep paying up.

High growth rarely lasts forever. Competitors arrive, markets fill up, and a larger company has to add ever bigger sums just to keep the same growth rate, which is why the slowing quarterly rates from the first lesson matter so much once you’re paying a premium price. Ask how many years of fast growth the price needs. Then ask whether that is believable.

Compare within an industry

A PEG of 1.5 means different things for a software company and a utility. Industries differ in how long growth tends to last, how much capital it takes, and how steady earnings are, so their PEGs sit at different levels for reasons that have nothing to do with bargains. Compare a company with its direct competitors. Two businesses selling similar things to similar customers give you a fair fight.

Quality counts too. A PEG built on earnings per share that are being diluted, or on growth bought with thinner margins, overstates what you get for the money, so run the checks from the lesson on growth that costs more than it earns before you trust the growth figure at all.

That finishes the method: measure growth, check what it cost, then decide what to pay. A good place to put it to work is a one-page stock case, where the growth rate, its quality and the PEG each get a line and a reason.