PEG Ratio

The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share, and the company's expected future growth. A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that gets close to 2 or higher is generally believed to be expensive, that is, the price paid appears to be too high relative to the estimated future growth in earnings.

It is a generally accepted rule of thumb that a PEG ratio of 1 represents a reasonable trade-off between cost (as expressed by the P/E ratio) and growth: the stock is relatively cheap for the expected growth. If a company is growing at 30% a year, then the stock's P/E could be as high as approximately 30. PEG ratios between 1 and 2 are therefore considered to be in the range of normal values.

When the PEG is quoted in public sources, it is considered preferable to use the expected future growth rate. Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.

For example, if HP is trading at a forward P/E of 35 times earnings. After making the comparison and discovering that rivals Dell Computer and Acer are both trading at multiples around 20, you might begin to think HP looks awfully expensive. But then you look at earnings growth. First, you see that HP's earnings are expected to grow at 40% annually over the next three to five years, while analysts are predicting Dell will grow at 15% and Gateway at 20%. That would give HP a PEG of 0.88, while Dell weighs in at 1.33 and Acer at 1. Dell doesn't seem so pricey after all.

Generally you use a forward P/E in the PEG ratio, but a low PEG using a trailing P/E is even more convincing. Anything below 1 is of interest, although there really are no rules of thumb. Like the P/E, different industries regularly trade at different PEGs. It's also true that the PEG works less well for large-cap companies that by nature grow at a slower rate despite strong prospects. As always, the key is to compare a company to its peers.