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L.13 · BEGINNER · 3 MIN

PEG Ratio: P/E Adjusted for Growth

Two stocks both trade at a P/E of 25. One grows earnings at 5% per year. The other grows at 25%. Are they equally expensive? Obviously not — but the P/E alone cannot tell you that. The PEG ratio is the standard normalizer: it divides the P/E by the growth rate, so you compare price PER UNIT OF GROWTH instead of price per dollar of current earnings.

Quiz · 5 questions ↓
§ 01
PEG = P/E Ratio / Earnings Growth Rate (%)
§ 02
PEG rangeConventional readCaveat
Below 1.0Potentially undervalued — the price is low relative to expected growth.Check whether the growth rate is realistic. Cheap-looking PEG often signals analyst estimates that are too optimistic.
Around 1.0Fairly priced for its growth — the Lynch baseline.Only meaningful if the growth rate is sustainable, not a one-year spike.
Above 1.5Pricing in growth more aggressively — the market expects a premium outcome.Common for high-quality compounders. Not automatically a sell signal.
Negative or undefinedUse a different metric — PEG breaks when earnings are negative or growth is zero.Early-stage and cyclical companies frequently fall here.
§ 03

Peter Lynch popularized PEG in the 1980s with a rule of thumb: PEG < 1 = undervalued, PEG > 1 = overvalued. The modern critique is that the rule works best for STEADY-GROWTH companies — established businesses with predictable earnings trajectories. PEG breaks for cyclical companies (businesses whose earnings rise and fall with the broader economy, like automakers and steelmakers) because next year's earnings might be a peak or a trough rather than a baseline. It also breaks for early-stage firms whose growth rates are volatile enough that any single year is misleading.

§ 04
Pick two stocks in the same sector with similar growth expectations but very different P/Es. Compute PEG for both. Often the higher-P/E stock has the LOWER PEG, because the market is paying up for justified growth. This is the wedge PEG opens up: P/E alone cannot tell you whether a 'cheap' stock is cheap for a good reason.
§ 05

PEG is only as good as the growth rate you feed it. Forward EPS — the analyst-consensus estimate for next year's earnings per share, as opposed to the trailing twelve-month figure — is an analyst estimate, and analyst estimates have known biases (too high near IPO, too low immediately after earnings beats). For a serious read, use a 3-to-5-year forward consensus (smooths the noise) or build your own growth model from revenue projections + margin assumptions. Trailing PEG (using last year's growth) is more conservative but lagged. Either way, PEG is a NORMALIZER, not a verdict — it's the first screen before the real work of judging whether the growth itself is durable.

§ 06

PEG turns the P/E ratio into a growth-adjusted yardstick. Use it to compare stocks at different growth profiles within the same sector. Be skeptical of the growth rate input, and never use PEG alone — it's a screening tool that points you at which businesses deserve a closer look, not a verdict on intrinsic value.

Five questions · AI feedback

Sit with the ideas.

Stock A trades at a P/E of 30 and grows earnings at 20% per year. Stock B trades at a P/E of 15 and grows earnings at 5% per year. Which stock has the lower PEG ratio?

Why:

Other lessons in this course.

  1. 01What is a P/E Ratio?
  2. 02EV/EBITDA: The Professional's Metric
  3. 03Price-to-Book: Asset Value
  4. 04Cost of Capital: What Discount Rate to Use
  5. 05Buybacks: When Returning Cash Beats Reinvesting It
  6. 06DCF: What Is a Company Really Worth?
  7. 07Putting It Together: Is This Stock Cheap?
  8. 08Mr. Market: Graham's Core Insight
  9. 09Circle of Competence: Buffett's Risk Framework
  10. 10Earnings Quality: Why Coca-Cola Trades at a Premium
  11. 11Earnings Predictability
  12. 12Capital Allocation: The CEO's Five Choices
  13. 13PEG Ratio: P/E Adjusted for Growth— reading now
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