As an offshoot of the P/E ratio, PEG is calculated by dividing a company's P/E by its growth rate. PEG is extremely popular with some investors because it seeks to relate the P/E to a piece of fundamental information--a company's growth rate. On the surface, this makes sense because a firm that is growing faster will be worth more in the future (all else being equal).
PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)
The problem with PEG is that risk and growth often go hand in glove--fast-growing firms tend to be riskier than average. This conflation of risk and growth is why PEG is frequently misused. When you use a PEG ratio alone to compare companies, you're basically assuming that all growth is equal, generated with the same amount of capital and the same amount of risk.
However, firms that are able to generate growth with less capital should be more valuable, as should firms that take on less risk. If you look at a stock that is expected to grow at 15% trading at 15 times earnings and another one that is expected to grow at 15% trading at 25 times earnings, don't just plunk your money down on the former because it has a lower PEG ratio. Look at the capital that each firm needs to invest to generate the expected growth, as well as the likelihood that those expectations will actually materialize, and you might very well wind up making a very different decision. But still, what PEG does give you is a quick and easy way to estimate the price you're paying for future growth.
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