What Is the PEG Ratio? Basics, Formula, and Risks

The PEG ratio is a valuation metric that compares a stock's P/E ratio to its expected or current earnings growth rate. Investors often use the PEG ratio to compare companies with different growth rates and quickly screen for reasonably priced stocks. The PEG ratio, because it accounts for growth, can offer a more holistic view of a stock's valuation than the P/E ratio alone.

The PEG ratio was developed by Mario Farina in 1969—and later popularized by fund manager Peter Lynch—to help determine if a stock's valuation is reasonable based on a company's expected future earnings growth.

The first step in calculating the PEG ratio is to calculate the P/E ratio by dividing a stock's price by earnings per share (EPS).

After that, find the EPS growth rate for the company. On Schwab.com, the annualized growth rate for one, three, and five-year periods is generally available under the Earnings tab.

Then, apply the PEG ratio formula:

PEG ratio = (Price/EPS) ÷ Annual EPS growth rate

The key is to use consistent inputs. A forward P/E ratio based on EPS estimates over the next 12 months should be paired with a forward-looking growth estimate, while a trailing P/E ratio based on EPS results over the past 12 months should be matched with a growth rate from the same period.

• Forward PEG example: If a stock has a forward P/E ratio of 20 and analysts expect earnings to grow 10% over the next year, the PEG ratio is 2 (20 ÷ 10 = 2).
• Trailing PEG example: If a stock has a trailing P/E ratio of 20 and its earnings grew 20% over the past 12 months, the PEG ratio is 1 (20 ÷ 20 = 1).

Many consider a PEG ratio of 1 to indicate a stock is "fairly valued" relative to the company's growth rate. A PEG ratio below 1 is sometimes interpreted as growth at a relatively low price, and a PEG ratio above 1 may suggest investors are paying a premium for growth.

These guidelines can be useful for quickly screening stocks, but context matters. Remember, PEG ratios vary across stock sectors and industries. Growth rates also may not be sustainable. And the implications of a PEG ratio can shift depending on whether historical growth, management guidance, or analyst estimates are used in the calculation process.

Investors often use the PEG ratio as a companion to the more popular P/E ratio. While the P/E ratio provides a look at what investors are willing to pay for a company's earnings, the PEG ratio takes earnings growth into account. This may help investors determine if a stock is potentially over- or undervalued relative to its current growth or expected growth potential. 

Some investors prize the PEG ratio because it helps them compare valuations of companies with different growth rates. For example, growth stocks tend to have higher P/E ratios than value stocks, but using PEG ratios, investors can potentially determine if a growth stock's higher P/E ratio is justified. Stocks with low P/E ratios can potentially be more "expensive" than high P/E stocks once growth rates are considered.

Essentially, the PEG ratio acts as a quick reality check for stocks labeled "cheap" or "expensive." A low P/E ratio may make a stock look "cheap," but if it has a high PEG ratio, it can suggest the low P/E ratio reflects weak or slowing earnings growth. Conversely, a high P/E ratio can signal overvaluation, but it can also signal that investors are pricing in faster future growth.

The key is to use the PEG ratio as a screening tool before investigating further. If a stock's PEG ratio looks unusually low or high versus its peers' ratios or its own history, dig into what's driving the growth assumptions and whether they're realistic.

In addition to helping investors quickly screen stocks and reality-check valuation labels, PEG ratios offer a few other benefits:

• Comparing valuations across sectors and industries. Like P/E ratios, PEG ratios vary by sector and industry. Higher-growth sectors like technology typically have higher PEG ratios than lower-growth sectors like utilities. However, PEG ratios can still help investors compare valuations of companies in different sectors or industries on a more level playing field than other valuation metrics.
• Finding Growth-At-A-Reasonable Price (GARP). Investors commonly use the PEG ratio to find companies with strong earnings growth that may not be as "expensive" as their P/E ratios suggest.
• Avoiding "value traps." When value investors find a stock with a low P/E ratio and seemingly strong financials, they'll often look at the PEG ratio to see if they're actually "value traps"—companies that appear undervalued but lack growth potential.

The PEG ratio isn't perfect and should only be considered one tool in an investor's larger toolkit. Here are a few risks to consider when using this valuation metric:

• Question the expectations. The PEG ratio is only as good as the growth rate used in the calculation. Forward growth estimates can be overly optimistic or pessimistic, making the PEG ratio unreliable. Analysts and companies also frequently change their growth forecasts, which can cause PEG ratios to fluctuate.
• Pay attention to the growth rate being used. PEG ratios can also use different growth rates in their calculations. Some analysts use the past year's EPS growth rate, others use the upcoming year's growth rate, and some even use speculative estimates about a company's growth over a three- or five-year period. The growth rate selected can make a dramatic difference in a company's PEG ratio.
• Pick the right spots. While many investors find PEG ratios useful, sometimes they should be viewed with skepticism. The PEG ratio can provide misleading valuations for mature companies with low growth rates, cyclical companies, and firms with very high growth rates that are potentially unsustainable.
• Watch the cash flow. The PEG ratio focuses on earnings growth, but two companies can have similar EPS growth while requiring very different levels of investment and debt to achieve that growth. Watching metrics like free cash flow (FCF) can help investors gauge the sustainability of a company's earnings growth.

The PEG ratio can be a helpful way to put a P/E ratio into context since it factors in expected earnings growth. But because it depends heavily on assumptions, it's best used as a starting point alongside other valuation metrics. Investors should always use fundamental analysis to thoroughly analyze a stock before making any investment decision.