FOOL SCHOOL
Valuation: The PEG Ratio

January 9, 2002

In the previous article we looked at the Price Earnings or P/E ratio. In this article we look at a related measure, the PEG or Price Earnings Growth Ratio.

The PEG ratio is calculated as:

Forecast P/E
---------------------
EPS Growth Rate

Say we have a share priced at 400p which is forecast to make earnings per share of 20p in the current year, having produced 15p last year. This means its forecast P/E is 20 (400/20) and its EPS growth rate is 33.3% (20p/15p - 1). Its PEG ratio is therefore 0.6 (20/33.3).

If possible it's better to use a growth rate over a number of years. Say you think that earnings growth over the next five years is more likely to be 20% rather than 33% then the PEG ratio would come out at 1 instead.

So what does number mean? A PEG below 1 is usually considered cheap. A PEG above 1 may be expensive. However, as with all valuation measures a pinch of salt is required. It is very hard to predict growth rates more than a couple of years ahead. If you only use a growth rate calculated over one or two years this may not be indicative of the long-term trend. You may catch a period when the company's profits are growing quicker than usual or merely pausing for breath. If you use the PEG in isolation there is a danger you will tend to catch fad shares that grow quickly over a short period of time before fizzling out.

The PEG was a popular tool during the late 1990s when the relatively calm economic conditions meant that growth rates tended to be more predictable. However, it is much less common to see it used these days when many companies are stuggling to grow their earnings at all. This is one of the main weaknesses of the PEG, it tends to break down at the extremes of low or very high growth. However, it can still be a useful tool for giving you an initial indication of whether a share requires further investigation.

Other valuation articles:
The PE ratio
Price to Sales
Dividend Yield
Return on Equity
Return on Equity and Goodwill
Uses of Return on Equity
Balance Sheet Basics
Discounted Cash Flow