The P/E-to-Growth ratio explained.

The price/earnings-to-growth (PEG ratio) ratio is a “valuation metric” that compares a company’s price-to-earnings to its EGR (expected growth rate). The metric can help investors value a stock by comparing the company’s market price, earnings, and future growth prospects.

A PEG ratio of 1 represents a perfect correlation between the P/E and the growth projection of the business. The PEG is a forward looking ratio which is quite different than other valuation ratios being used.

If a company’s PEG ratio is above 1, it is considered overvalued, and if it is below 1, it is considered undervalued. The G = EGR (Earnings Growth Rate) is typically made up of the 1–5-year growth rate, as anything longer than that can be unpredictable. A higher PEG means you are paying more for the growth of that company and the stock price is not supported by growth forecasts.

The PEG ratio helps investors put a price on the company’s rate of growth to ensure they are not overpaying unless they see the company delivering beyond the EGR. It is better than the P/E ratio as it takes into account growth. The 1 in the PEG ratio represents a fair price between the cost and value of the share price and the values of future growth.

To determine the rate of growth, we need to look at past earnings and growth rates to form our base of what to extrapolate into the future. While past performance is no indicator of future performance, it can give us an idea of whether growth is slowing or growing to help us form our future growth rate.

For instance, a company with a P/E of x20 and an expected rate of growth of 20% annually (taken from the average past growth) over the next 5 years has a PEG ratio of 1. This means that the current share price is in line with the fair value for what the company is expected to produce.

What is the P/E-to-Growth formula?

• PEG Ratio = P/E ÷ EGR (Expected Growth Rate)
• P/E Ratio = Price per Share ÷ Earnings Per Share

How to work out the Expected Growth Rate?

It is best to use a sustainable long-term growth rate. To calculate the EGR for a company, look back over the last 5 years of the company’s growth and calculate the CAGR (Compounded Annual Growth Rate). Account for any slowing down of the growth rate. Cross-check the EGR with the company guidance and analyst forecasts.

Working out Expected Growth Rate from the EPS guidance or analyst forecast?

In a highly simplified example, let us assume we have a company that has an earnings expectation of $1.50 for Year 1 and $2.20 for Year 2. We would simply find the expected growth rate by taking the Year 2 forecast of $2.20 minus the Year 1 forecast of $1.50 and then divide the difference by the first year.

EGR % = $2.20 ÷ $1.50 = 0.46 x 100 = 46.66% (This would create the bottom half of our formula).

How to use the PEG Ratio?

Like all valuations, comparing apples for apples is important when using the PEG ratio. The industry, company size and business cycle are all important. Some businesses are challenging because if there are negative earnings it becomes hard for unprofitable companies to create an accurate P/E ratio which is the top half of the formula. This is why I don’t find it useful for early-stage, hyper-growth businesses yet to pass the breakeven point.

Let’s take a look at an example of 3 companies and determine the value based on the PEG ratio.

PEG RATIO	Company A	Company B	Company C
P/E Ratio	22	25	42
Growth Rate	25%	12%	41%
PEG %	0.88	2.08	1.02

Company A 22 ÷ 20 = PEG 0.88

Company B 25 ÷ 12 = PEG 2.08

Company C 41÷ 41 = PEG 1.02

If we look at the 3 companies in terms of valuation, we can see that Company A is undervalued as the PEG falls below 1, Company B is overvalued by a factor of 1.08 and Company C seems to be fairly valued as the P/E ratio coincides with the Expected Growth Rate. If we were basing the investment around this information Company A with the lowest PEG presents the best value.

One interesting point that the PEG ratio is useful for is removing the idea of OVER or under-valuation based purely on the Price-to-earnings ratio. Considering the additional factor in the PEG, it does present the company in a different light. Company C has a high P/E ratio and may be deemed overvalued. However, comparing it against the future projections of growth, the correlation creates a context for which we can assess what true value is.

If Company C had a P/E of 42 and an EGR of say 5%. That would equate to a PEG of 8.4 which would be considered Overvalued and then the P/E would reaffirm that it is. Growth is what makes this ratio important.  

Growth in Earnings Per Share is a very important fundamental to consider, that is what ultimately drives share price growth in the long run. A lower P/E ratio is considered cheap, but if it has a low growth rate, we are only waiting for the price to close the gap to intrinsic value and not counting on long-term compounding of growth to carry us forward. This is how the PEG reframes “value”, we can have a company with a high P/E of 40 and sustainable growth at 50% annually and still be considered CHEAP with a PEG of 0.8.

There can be a negative PEG and it can come from a lot of factors but usually indicates that a company may be losing money or is expected to have negative growth.

As an interesting visual of how different the PEG can be based on the growth rate let us compare 3 investments, all with the same share price, the same EPS and the same P/E yet with vastly different growth rates, what this will show is how simple yet effective this reframing of value really is.

PEG RATIO	Company A	Company B	Company C
Last Closing Share Price	$25	$25	$25
Earnings Per Share	$2.00	$2.00	$2.00
P/E Ratio	12.5	12.5	12.5
Long Term Growth Rate	10%	20%	6%
PEG Ratio	1.25	0.62	2.08

We can see that out of 3 companies the one that has the highest growth rate produces the lowest PEG of 0.62 which shows how undervalued Company B is to its peers.

In Summary…

Many investors and analysts rely heavily on the PEG ratio to evaluate the value of a company. However, I prefer not to use it in isolation and only use it as a quick snapshot when determining value. This is because the PEG ratio is an estimate of future growth and when changing this multiple, it can have drastically different outcomes to the final number.

If I am screening for ideas or see a good company on my watchlist and I observe the PEG ratio drop, I want to know why and what has caused this as it may present an opportunity to take a position at a better price. For instance, if a company gets punished and the price moves against the earnings, yet the growth is still expected to be strong, that dislocation of the P/E to the Growth rate presents the value play for me.

One advantage of the PEG ratio is that it compels you to think and dig a little deeper than other ratios. Unlike the P/E ratio, which is simple to calculate, the PEG ratio requires you to evaluate growth, past performance, and the likely rate it could be. This exercise is good as it requires a little more thought than screening for high or low multiples, which can be misleading.