PEG and Growth-Adjusted Multiples

A stock trading at a price-to-earnings (P/E) ratio of 30 looks expensive next to one trading at 15, until you notice the first company is growing earnings at 25% a year and the second at 3%. A high P/E can be entirely justified if earnings are growing fast enough to catch up to that price over time, so comparing raw P/E ratios across companies with very different growth rates can be misleading.

The PEG ratio adjusts for this by dividing the P/E ratio by the company's expected annual earnings growth rate (expressed as a plain number, not a percentage): PEG = P/E ÷ growth rate. A PEG near 1 is the traditional rule-of-thumb marker for "fairly priced relative to growth," below 1 suggests the stock may be cheap for its growth rate, and above 1 suggests investors are paying a premium for that growth.

Worked example. Company A trades at a P/E of 30 and is expected to grow earnings 25% a year: PEG = 30 / 25 = 1.2. Company B trades at a P/E of 15 but is only expected to grow earnings 3% a year: PEG = 15 / 3 = 5.0. Despite its much lower P/E, Company B's PEG is far higher, suggesting it may actually be the more expensive stock once its slower growth is accounted for, the opposite conclusion a simple P/E comparison would have given.