The P/E ratio tells you how much investors pay for a company's current earnings. But it says nothing about growth. Two stocks can have identical P/E ratios while one grows at 5% and the other at 25%. The PEG ratio solves this by incorporating growth into valuation.
Definition of PEG Ratio
The PEG ratio, or price/earnings to growth ratio, adjusts the P/E ratio by dividing it by the company's expected earnings growth rate. Popularized by investor Peter Lynch, it offers a quick way to identify stocks where the price is reasonable relative to growth.
Where P/E measures what you pay for current earnings, PEG measures what you pay for each unit of earnings growth. A company with a P/E of 30 growing at 30% has a PEG of 1.0, suggesting price is proportional to growth. A company with P/E of 15 but only 5% growth has a PEG of 3.0, paying significantly more per unit of growth.
PEG Formula and Calculation
The formula is straightforward:
PEG Ratio = P/E Ratio / Annual EPS Growth Rate
The P/E ratio uses the stock's current price divided by earnings per share. The growth rate is typically the expected annual EPS growth over the next three to five years, based on analyst consensus estimates.
Worked example
A stock trades at $50 per share with EPS of $2.50. The P/E ratio is 20. Analysts expect the company to grow EPS at 15 percent annually over the next five years. The PEG ratio is 20 / 15 = 1.33.
Which growth rate to use
Some investors use historical EPS growth, others use forward estimates. Forward PEG ratios are more common because valuation is about the future.
However, forward estimates carry uncertainty since analyst projections can shift. A blended approach considering both historical consistency and forward estimates provides a more balanced view.
Interpreting PEG Values
The general guidelines for reading PEG ratios are simple but require context.
- A PEG of 1.0 is often cited as the benchmark of fair value. It suggests the stock's price is in line with expected growth. Peter Lynch considered PEG of 1.0 as the threshold: below it, potentially undervalued; above it, potentially overvalued.
- A PEG below 1.0 can signal that the market has not fully priced in growth potential. This could represent an opportunity, but it may also reflect legitimate concerns about sustainability or business risk.
- A PEG above 2.0 generally suggests investors are paying a premium beyond what growth justifies. This is common in growth stocks with strong momentum, where investors pay for perceived quality and competitive moats.
These thresholds are guidelines, not rules. High-quality technology companies routinely trade at elevated PEG ratios because the market assigns premiums to predictable, scalable growth.
PEG vs P/E Ratio
The P/E ratio is a snapshot of current valuation. The PEG ratio adds a dimension by incorporating expected growth.
P/E works well when comparing companies with similar growth rates within the same sector. If two utility companies both grow at roughly 4%, comparing P/E ratios gives a meaningful relative signal.
PEG becomes essential when comparing companies with different growth profiles. A tech company growing at 25% and a consumer staples company growing at 5% cannot be meaningfully compared on P/E alone. PEG normalizes for growth.
However, PEG depends on growth estimates that are inherently uncertain. Earnings expectations shift constantly as companies report results and update guidance. A PEG ratio is only as reliable as the growth forecast behind it.
Using both metrics together provides the clearest picture.
When PEG Works Best
The PEG ratio is most effective under specific conditions and for certain types of companies.
Profitable growth companies
PEG requires positive earnings and positive growth. It does not work for pre-profit companies or businesses with declining earnings.
The ideal candidates are established companies with consistent, measurable EPS growth trajectories.
Sector comparison
Comparing PEG ratios within the same industry yields the most useful signals. A PEG of 1.2 might be cheap in technology but expensive in utilities.
Sector norms differ because growth expectations and risk profiles vary across industries.
Screening tool, not final answer
PEG works best as a first filter in fundamental analysis, narrowing a universe of stocks to those worth deeper investigation.
It should be combined with balance sheet analysis, margin trends, and competitive positioning before making decisions.
When it falls short
PEG is less useful for cyclical companies with volatile earnings, early-stage companies without profit history, and situations where growth estimates are highly uncertain. It also does not account for debt levels or cash flow quality.
Conclusion
The PEG ratio bridges value and growth analysis by asking: are you paying a fair price for this company's growth? It transforms the P/E ratio from a static snapshot into a growth-adjusted metric.
Like any single metric, PEG should not drive decisions alone. But as a screening tool, it helps investors avoid overpaying for slow growth and overlooking fast growers that appear expensive on P/E alone.
FAQ
What is a good PEG ratio?
A PEG of 1.0 is generally considered fair value. Below 1.0 may indicate undervaluation relative to growth, while above 2.0 suggests investors are paying a significant premium beyond growth expectations.
Is PEG ratio better than P/E ratio?
PEG adds growth context that P/E lacks, making it more useful for comparing companies with different growth rates. However, it depends on growth estimates that may be inaccurate. Using both together provides the best insight.
Can PEG ratio be negative?
Yes, if either earnings or growth are negative. In these cases, the PEG ratio is not meaningful and should not be used for valuation.
References
- Investopedia, Price/Earnings-to-Growth (PEG) Ratio: What It Is and the Formula, 2026.
- CFA Institute, Equity Valuation: Concepts and Basic Tools, 2026.
