Price-to-Earnings divided by the expected earnings growth rate — a valuation shortcut that adjusts the P/E ratio for a company's growth, making high-P/E growth stocks comparable.
“The P/E ratio of any company that's fairly priced will equal its growth rate.”
— Peter Lynch
Deeper Explanation
The PEG ratio (Price/Earnings-to-Growth) was popularised by Peter Lynch as a simple tool for assessing whether a growth stock's valuation is justified by its growth rate. The calculation is straightforward: take the P/E ratio and divide it by the expected annual earnings growth rate (expressed as a percentage). A company with a P/E of 20 and 20% expected growth has a PEG of 1.0; a company with a P/E of 30 and 15% expected growth has a PEG of 2.0. Lynch suggested that a PEG below 1.0 generally indicated an undervalued growth stock, a PEG around 1.0 was fair value, and a PEG significantly above 1.0 suggested the growth premium was more than priced in. These are rules of thumb, not scientific laws. The PEG ratio's greatest value is making P/E ratios comparable across companies with very different growth rates. A company with a P/E of 40 looks expensive in isolation but may be cheap if it is growing earnings at 50% annually. A company with a P/E of 15 looks cheap in isolation but may be expensive if earnings are growing at only 5% annually. Its limitations are equally important to understand. The PEG ratio is only as reliable as the growth rate estimate — and growth estimates are frequently wrong. It assumes growth is linear and sustainable, which it rarely is. It does not account for balance sheet quality, capital requirements, or the certainty of the growth estimate. A highly cyclical business with volatile earnings and a temporarily high growth rate will produce a misleadingly attractive PEG. Lynch used it as a starting filter, never as a final verdict.
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