PEG Ratio
IntermediateThe PEG ratio is a company's price-to-earnings ratio divided by its expected annual earnings growth rate. It adjusts the P/E ratio for growth.
A high P/E ratio can be justified if a company's earnings are growing quickly. The PEG ratio tries to show whether investors are paying a reasonable price for that growth.
It is calculated by dividing the P/E ratio by the expected earnings growth rate, expressed as a whole number. For example, a company with a P/E of 20 and expected earnings growth of 10% a year has a PEG ratio of 2. A company with a P/E of 30 and expected growth of 30% has a PEG ratio of 1.
A common rule of thumb is that a PEG ratio around 1 suggests a fair price for growth, while a ratio well above 1 may suggest the share is expensive relative to its growth and below 1 may suggest it is cheap.
The PEG ratio has limitations. It depends on growth forecasts, which can be wrong. It does not account for risk, dividends or the quality of earnings. And it treats growth in a simple way that does not suit companies with very high, very low or negative growth. It is best used as a quick screening tool rather than a full valuation.
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