Dividing the Multiple by Growth to Compare Companies
A high price earnings ratio can be justified by high growth. The PEG ratio divides one by the other to compare companies growing at different rates, and it is more useful as a rough check than a precise tool.
The Problem the PEG Ratio Addresses
The price to earnings ratio, comparing a stock price to its earnings, is the most common valuation measure. But it has a well known limitation: it does not account for growth. A company growing quickly deserves a higher multiple than one growing slowly, because its earnings will be much larger in the future, so comparing the raw multiples of two companies growing at different rates is misleading.
The PEG ratio addresses this by dividing the price to earnings ratio by the earnings growth rate. It attempts to put companies growing at different speeds on a comparable footing, so that a high multiple justified by high growth can be distinguished from one that is simply expensive.
A high multiple is not the same as expensive. The PEG ratio tries to separate stocks that are dear because they grow fast from stocks that are just dear.
How It Works
The calculation is simple: divide the price to earnings ratio by the percentage growth rate of earnings. A company with a high multiple but correspondingly high growth produces a moderate PEG ratio, while a company with a high multiple and low growth produces a high PEG, flagging it as expensive relative to its growth.
| Company | P/E | Growth | PEG |
|---|---|---|---|
| Fast grower | 30 | 30% | 1.0, reasonable |
| Slow grower on high multiple | 30 | 10% | 3.0, expensive |
| Modest grower on low multiple | 12 | 12% | 1.0, reasonable |
A rough rule of thumb treats a PEG around one as fairly valued, below one as potentially cheap, and above one as potentially expensive, on the logic that the multiple should roughly match the growth rate. The rule is crude but it captures the useful idea that growth justifies a higher multiple.
Why It Is a Rough Tool
The PEG ratio is popular because it is simple and captures a real insight, but it is a rough tool with genuine flaws that stop it from being a precise measure.
The idea that a fair multiple should equal the growth rate has no strong theoretical basis; it is a convenient approximation rather than a principle. The ratio also depends heavily on the growth rate used, which is a forecast and therefore uncertain, and small changes in the assumed growth rate swing the PEG substantially. And it ignores risk: two companies with the same PEG can have very different risk, and the riskier one deserves a lower multiple, which the PEG does not capture.
The Growth Rate Problem
The biggest weakness is the growth rate itself. The PEG requires a growth rate, and which one to use is unclear: past growth, which may not continue, or forecast growth, which is uncertain and often optimistic. The ratio is only as good as the growth figure plugged in, and that figure is exactly the hardest thing to know.
High growth rates are also unsustainable, since no company grows rapidly forever, so applying a current high growth rate to justify a multiple assumes the growth persists longer than it usually does. A company growing very fast now may have a low PEG that looks attractive, while the growth is about to slow, which the ratio does not warn about.
Where It Is Useful
Despite its flaws, the PEG ratio is useful as a quick screen and a rough comparison, particularly among growth companies where the plain price to earnings ratio is most misleading. It offers a fast way to flag whether a high multiple is supported by growth or not, which is a genuinely useful first cut.
It works best as a starting point that prompts deeper analysis rather than as a conclusion. A low PEG suggests a stock may be reasonably priced for its growth and worth investigating; a high PEG suggests the price may not be justified by growth and warrants caution. Used this way, as a rough filter rather than a precise valuation, it earns its popularity.
The Bottom Line
The PEG ratio divides the price to earnings ratio by the earnings growth rate to account for the fact that faster growing companies deserve higher multiples, offering a quick way to compare growth stocks. Its rule of thumb, that a PEG around one is fair, captures a real insight but has no firm theoretical basis, ignores risk, and depends entirely on an uncertain growth forecast that is often unsustainable. It is best used as a rough screen to flag whether a high multiple is justified by growth, prompting further analysis rather than serving as a precise measure.