The PEG ratio considers the impact of earning growth on the P/E ratio. It is calculated as P/E divided by the expected earnings growth rate in percentage. Stocks with lower PEG ratios are more attractive than those with higher PEG ratios. A PEG ratio of less than one would be considered an attractive investment level.

However, the PEG ratio has several limitations:

• It assumes a linear relationship between P/E and growth.
• It does not factor in differences in risk.
• It does not account for differences in the duration of growth.

Example: PEG Ratio

A company with a forward P/E ratio of 9.21 and a 5-year EPS growth forecast of 12% would have a PEG ratio of 0.76 calculated as follow:

$$\text{PEG}=\frac{9.21}{12}=0.76$$

Question

Consider a company with a forward P/E ratio of 8.20 and a 5-year EPS growth forecast of 13%. The PEG would be closest to:

1. 0.42.
2. 0.63.
3. 63.07.

Solution

The correct answer is B.

$$\text{PEG}=\frac{8.20}{13}=0.63$$

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (k) Calculate and interpret the P/E- to- growth ratio (PEG) and explain its use in relative valuation.