PEG RATIO

Hello everyone, welcome back. Today, we are examining another important financial concept: the PEG ratio, also known as the price-to-earnings-to-growth ratio.

Where it came from

The PEG ratio was introduced back in 1969 by Mario Farina, in his book on investing in the stock market. The idea behind it was simple. Investors wanted a deeper way of judging whether the price of a stock was actually justified by the value of the company behind it. Later, the legendary fund manager Peter Lynch popularised the measure and made it part of mainstream investing.

Why it changed the game

Most people are familiar with the P/E ratio, which is simply the share price divided by the company's earnings per share. It tells you how expensive a stock looks, but it stops there. It says nothing about where the company is headed.

That is the gap the PEG ratio fills. It brings growth into the picture.

Imagine two companies, both trading at a P/E of 40. On the surface they look equally expensive. But suppose the first is growing its earnings at 10 percent a year while the second is growing at 40 percent. Those are two completely different investments, and the P/E ratio alone would never show you that. The PEG ratio reveals exactly this difference.

How to calculate it

$$\text{PEG} = \frac{\text{P/E Ratio}}{\text{Annual Earnings Growth Rate}}$$

PEG=Annual Earnings Growth Rate P/E Ratio​

Take our two companies from earlier:

	Company A	Company B
P/E ratio	40	40
Growth rate	10 percent	40 percent
PEG	4.0	1.0

Identical on P/E. Completely different on PEG.

How to read the result

Above 1 means the stock is expensive relative to how fast the company is growing. You are paying a lot for each unit of growth.

Around 1 means the stock is fairly priced. The price and the growth are roughly in balance.

Below 1 means the stock may be cheap relative to its growth, and could be undervalued.

A word of caution

The PEG ratio depends on a growth forecast, and forecasts can be wrong. It also breaks down for companies with very low or negative earnings. Treat it as one useful lens among several, not as a verdict on its own.

That is the PEG ratio. See you in the next one.