The price earnings to growth ratio (PEG ratio) attempts to determine a share’s value by taking into account the company’s earnings growth. It gives a potential indication as to how the market values the share’s growth potential in relation to the earnings per share (EPS) growth. The formula used to calculate the PEG ratio is as follows:

For example the PEG ratio for a company that has a PE ratio of 15 and an annual earnings growth rate of 10% would be 1.5.

The PE ratio compares a company’s share price to its earnings per share (EPS). The PEG ratio in turn compares this PE ratio to the projected EPS growth rate. Assuming that the stock market correctly priced a share by taking into account a company’s future growth, a PEG ratio of 1 would indicate that the share’s anticipated EPS growth is fully reflected in the current share value as expressed in its PE ratio.

Similarly to the PE ratio, interpretations of the PEG ratio can vary. A PEG ratio greater than 1 could mean that a share is overvalued, but it could also mean that investors are willing to pay a higher share price because they expect fast growth in the future.

Likewise PEG ratios of under 1 may indicate that a share is undervalued and the market does not expect the company to meet its earnings forecasts; or that the market has not recognised and correctly priced the share relative to the company’s earnings growth potential.

Therefore, the PEG ratio must be used in conjunction with other indicators and ratios to give a more complete picture of a share’s value. In particular the company’s fundamentals, business strategy and the drivers of EPS growth must be evaluated to put the PEG ratio in perspective. At the same time a company’s PE and PEG ratio should be compared to their historic values and to the PE and PEG ratios of other companies from the same industry.

It is important to remember that the PEG ratio is a mere rule of thumb and not based on mathematical relationship, as it compares a fraction (PE ratio) to a percentage (EPS growth). The underlying mathematical basis becomes particularly questionable for companies that have low or no earnings growth.

For these companies the PEG ratio leads to results that cannot be deemed a fair price. However, the PEG ratio gives a good indication of the growth/price trade-off of shares with fast growing earnings. In practice, it is therefore only used for companies that display at least average growth rates.

When comparing different PEG ratios the assumptions underlying EPS growth forecasts also need to be considered. Firstly, due to their predictive nature these may be quite inaccurate. Secondly, different timeframes for the forecasts from one to several years may be used. Ideally the earnings forecasts should be based on sustainable growth estimate over several years, but frequently earnings estimates for the following year, and in some cases even the trailing EPS growth, are used.