PEG ratio: the P/E measured against earnings growth

Definition

The PEG ratio divides the P/E by the expected annual growth rate of earnings per share, expressed in points. It corrects the main flaw of the P/E, which penalizes fast-growing companies: a P/E of 30 can be moderate for a company whose earnings grow by 30% a year, and high for another growing by 5%.

Where to find it in an annual report

The P/E is calculated with the share price and the earnings per share at the bottom of the income statement. Expected growth cannot be read directly: start from past EPS growth, over 3 to 5 annual reports, and from the outlook in the management report. Use a rate you consider sustainable over several years, not the best year.

Common thresholds

Reasonable growth: 1 at most for green, up to 2 for orange, red above. The benchmark of 1, popularized by Peter Lynch in “One Up on Wall Street”, says that the P/E does not exceed the growth rate. Below 0.5, the valuation looks very low relative to the growth assumed, which is a reason to check that growth.

Pitfalls

• The PEG is only as good as the growth rate used: a few points more or less change the result completely.
• Very strong past growth almost always slows as a company gets bigger: extending it as it is flatters the ratio.
• The PEG ignores the dividend: for a company that pays out a lot, some add the yield to the growth rate.
• The PEG ignores debt and the quality of growth (organic or through acquisitions).

Where it does not apply

• Loss-making companies or those with very low earnings: the P/E makes no sense, and neither does the PEG.
• Mature companies with low growth (less than 5% a year): the ratio becomes very high without the valuation being excessive.
• Cyclical companies, whose growth in a given year depends mainly on where they are in the cycle.