Valuing growth: Peter Lynch's PEG ratio
A high P/E ratio does not automatically mean expensive – if earnings grow fast, the price can be justified. The PEG ratio sets the P/E ratio against expected earnings growth. Peter Lynch considered a company fairly valued when the two are roughly equal.
The idea
The P/E ratio tells you how many years of earnings you pay for a share. It does not tell you how fast those earnings are growing. A company with a P/E of 30 can be cheaper than one with 12 – if its earnings rise strongly every year and the other's barely move.
Peter Lynch, who ran one of the most successful funds in the US for many years, popularised a simple rule of thumb for this: the P/E ratio of a fairly valued company is about equal to its growth rate. That is where the PEG, the "price/earnings to growth" ratio, comes from.
The formula
- P/E ratio
- share price divided by earnings per share
- Growth
- expected annual earnings growth, as a number: 20% = 20
Important: growth goes in as a whole number here, not as a decimal. A P/E of 20 with 20% growth gives a PEG of 20 ÷ 20 = 1.
The worked example
Three made-up companies, three P/E ratios. By P/E alone, Company B would be the cheapest:
| Company | P/E · growth | PEG |
|---|---|---|
| Company A | 30 · 25% | 1.2 |
| Company B | 12 · 4% | 3.0 |
| Company C | 18 · 20% | 0.9 |
With growth in view, the picture turns around. Company B has the lowest P/E, but barely grows – measured against growth it is the most expensive. Company C is the cheapest, even though its P/E is higher than B's.
Lynch's rule of thumb
Lynch read the ratio roughly like this: a PEG around 1 points to a fair price. Clearly below 1 can be an opportunity, clearly above 2 a sign that a lot of future is already in the price. It is a rule of thumb, not a law – it does not replace a look at the business.
Lynch was also cautious about very high growth. Few companies sustain rates above about 25% a year for long. A PEG that rests on a short growth spurt should therefore be read with care.
Which growth?
The PEG is only as good as the growth figure. What is meant is expected earnings growth over the next few years, not last quarter's jump. Many use analysts' estimates for the next three to five years, or past growth if the business is stable. Ideally you compare both: if the expectation differs a lot from the past, ask yourself why.
Where the PEG does not help
For companies without profit there is no P/E and therefore no PEG. For companies with very little growth the number quickly becomes huge and says little. And for banks, insurers or real estate companies there are better measures that fit their business.
Three common mistakes
Value growth the Peter Lynch way.
Delta Metron runs a growth model after Peter Lynch: earnings per share, growth and fair P/E, every assumption visible and adjustable by you – for more than 6,000 stocks. Sign up for free: The first 100 on the waitlist pay €5 instead of €10 a month at launch, for life.
Frequently asked questions
What is a good PEG?
By Lynch's rule of thumb, a PEG around 1 is fair and clearly below that is cheap. What matters most, though, is how solid the assumed growth is.
What about dividends?
For companies that pay out a lot, Lynch also took the dividend yield into account: he added it to growth before comparing with the P/E. That way slow-growing but generous companies do not come off too badly.
Does the PEG replace a DCF?
No. The PEG is a quick comparison, the DCF a detailed calculation. Together they give a better picture than either on its own.
Does the PEG work with losses?
No. Without profit there is no meaningful P/E and therefore no PEG. Revenue or cash flow measures help more then.
Not investment advice. All content is for informational and educational purposes only. Companies A, B and C are made up.