The PEG scales the P/E by growth in one division, and in doing so assumes a share's multiple should rise in proportion to its growth rate.
The PEG ratio is the P/E ratio divided by the expected annual growth rate of earnings per share, with the growth rate entered as a whole number. A share at 60 with earnings per share of 2.00 trades on a P/E of 30.0; if earnings are expected to grow 25 per cent a year, the PEG is 30.0 / 25 = 1.20. A PEG of 1.0 is the usual reference point, but the ratio is only as good as the growth estimate under it, and it can rank companies in the wrong order.
Worked in full in Stock Market Investing for Beginners by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The P/E tells you how many years of today's earnings the price represents. It says nothing about whether those earnings will be larger next year. The PEG tries to fix that by scaling the multiple by growth, on the idea, popularised by Peter Lynch, that a company growing earnings at 25 per cent a year can justify a higher multiple than one growing at 8. The calculation takes ten seconds. Reading it correctly takes longer.
| Company | Share price | EPS, last 12 months | Expected EPS growth a year | Dividend yield |
|---|---|---|---|---|
| Alder | 60.00 | 2.00 | 25.0% | 0.0% |
| Birch | 36.00 | 3.00 | 8.0% | 4.0% |
| Cedar | 45.00 | 2.50 | 15.0% | 1.0% |
The growth rate is the expected compound annual growth of earnings per share over the next few years, usually five. Where it comes from matters more than anything else in the ratio: an analyst consensus, the company's own guidance, or your own estimate will give three different PEGs for the same share.
P/E = share price / earnings per share
Alder: 60.00 / 2.00 = 30.0. Birch: 36.00 / 3.00 = 12.0. Cedar: 45.00 / 2.50 = 18.0. How to read the P/E itself is covered in what is a good P/E ratio.
PEG = P/E / (expected annual EPS growth × 100)
Alder: 30.0 / 25 = 1.20. Birch: 12.0 / 8 = 1.50. Cedar: 18.0 / 15 = 1.20.
Excel, with price in B2, EPS in C2 and growth as a percentage in D2: =(B2/C2)/(D2*100)
| Company | P/E | Growth | PEG | EPS in year 5 | Price / year-5 EPS |
|---|---|---|---|---|---|
| Alder | 30.0 | 25.0% | 1.20 | 6.10 | 9.8 |
| Birch | 12.0 | 8.0% | 1.50 | 4.41 | 8.2 |
| Cedar | 18.0 | 15.0% | 1.20 | 5.03 | 8.9 |
On PEG alone, Alder and Cedar tie at 1.20 and Birch looks the most expensive at 1.50. Now carry the growth forward. If every estimate is met, Alder's earnings per share compound by 3.05 times over five years, to 6.10, Cedar's by 2.01 times and Birch's by 1.47 times. Divide today's price by year-5 earnings and the order reverses: Birch is at 8.2 times, Cedar at 8.9 and Alder at 9.8.
The reason is arithmetic, not opinion. The PEG assumes a share's multiple should rise in proportion to its growth rate, so 25 per cent growth justifies 3.1 times the P/E of 8 per cent growth (25 / 8). Five years of compounding does not deliver that: Alder's earnings grow 3.05 times against Birch's 1.47 times, a ratio of 2.1. Alder's price only catches up with Birch's against earnings if the 25 per cent rate holds beyond year six, so the PEG quietly assumes a runway that the single figure never states.
Dividends are the second gap. Birch pays out a 4.0 per cent yield; Alder pays nothing and reinvests. A plain PEG gives Birch no credit for the cash. The dividend-adjusted version, sometimes called PEGY, divides the P/E by growth plus yield:
PEGY = P/E / (growth + dividend yield)
Birch: 12.0 / (8 + 4) = 1.00. Cedar: 18.0 / (15 + 1) = 1.12. Alder: 30.0 / (25 + 0) = 1.20.
None of this makes any of the three a better or worse purchase. It shows that the same three companies can be ranked in two opposite orders depending on which simple ratio you choose, which is reason enough not to rely on one.
The growth rate is a forecast, and the PEG moves one for one against it. Here is Alder, holding the price and current earnings fixed.
| EPS growth a year | PEG | EPS in year 5 | Price / year-5 EPS |
|---|---|---|---|
| 10% | 3.00 | 3.22 | 18.6 |
| 15% | 2.00 | 4.02 | 14.9 |
| 20% | 1.50 | 4.98 | 12.1 |
| 25% | 1.20 | 6.10 | 9.8 |
| 30% | 1.00 | 7.43 | 8.1 |
For Alder to reach the reference PEG of 1.0, growth has to be 30.0 per cent a year. If it turns out to be 15 per cent, the same price is 14.9 times year-5 earnings rather than 9.8. A high P/E is a bet on the growth rate, and the PEG makes that bet look more precise than it is.
Low growth breaks the ratio. At 2 per cent expected growth, a modest P/E of 12.0 gives a PEG of 6.0, and Alder's 30.0 would give 15.0. For mature companies with slow growth and high dividends, the plain PEG says very little; at zero or negative growth it cannot be calculated at all.
The growth figure itself should be a compound annual rate, not an average of yearly percentages, for the reason set out in how to calculate CAGR and why it is lower than the average.
Compute the PEG as P/E divided by growth in whole numbers, then check it against what the price means for earnings five years out and, where there is a dividend, against the PEGY. Here two shares tie at 1.20, the one at 1.50 is the cheapest against year-5 earnings, and a five-point miss on the growth estimate moves Alder from 1.20 to 1.50. The ratio is a question to ask of a valuation, not an answer. What compounding and costs do to a long-term portfolio is put into figures in the free workbook for this case.
A PEG of 1.0, where the P/E equals the expected growth rate, is the usual reference point, and figures below it are often read as cheap for the growth on offer. The threshold assumes the growth estimate is right: a share on a P/E of 30.0 needs 30.0 per cent annual growth to reach 1.0, and at 15 per cent growth its PEG is 2.00. Treat it as a prompt to examine the growth forecast, not as a verdict.
PEGY adds the dividend yield to the growth rate before dividing, so a company that pays out cash is not penalised for growing more slowly. A share on a P/E of 12.0 with 8 per cent growth has a PEG of 1.50; with a 4.0 per cent dividend yield its PEGY is 12.0 / (8 + 4) = 1.00. For high-yielding, mature companies PEGY is the fairer of the two.
Either, as long as every company in the comparison uses the same basis. A share at 60.00 with trailing EPS of 2.00 and next year's expected EPS of 2.50 has a trailing P/E of 30.0 and a forward P/E of 24.0, so with 25 per cent growth its PEG is 1.20 trailing and 0.96 forward. Mixing the two across companies produces a ranking that reflects the method, not the shares.
This article is one calculation from Stock Market Investing for Beginners. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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