PEG Ratio

The PEG ratio adjusts the P/E ratio for growth by dividing a stock's price-to-earnings multiple by its expected earnings growth rate. It addresses a fundamental limitation of P/E: two stocks with identical P/E ratios can be very different investments if one is growing at 30 percent and the other at 5 percent.

A PEG of 1.0 suggests the stock is fairly valued relative to its growth rate. Below 1.0 may indicate the stock is undervalued given how fast earnings are growing. Above 1.0 suggests investors may be paying a premium that growth alone does not justify.

Practical Application

PEG is particularly valuable when evaluating growth stocks where raw P/E numbers can appear extremely high. A technology company with a P/E of 40 and 40 percent growth has a PEG of 1.0 — fairly valued. The same P/E with 15 percent growth gives a PEG of 2.7 — investors may be overpaying.

The main limitation is that PEG relies on growth estimates, which are inherently uncertain. If analysts project 25 percent growth but the company delivers only 15 percent, the PEG calculation was based on faulty input. Always consider whether the expected growth rate is realistic.