PEG Ratios

Abstract

High price-earnings ratios are often justified by high growth rates in corporate earnings. In recent years, many analysts have turned to the ratio of the PE ratio to the growth rate (the PEG ratio) in an effort to control for this relationship. In fact, the PEG ratio is not a constant that can be used to decide whether a stock is cheap or not. Rather, a plot of the relationship of the justifiable PEG to the growth rate is u-shaped for a wide range of parameter values. The level of the justifiable PEG for a given growth rate also depends on the length of the rapid growth period, the sustainable growth rate in the long run, and the discount rate. The PEG levels of 1.0 or 1.5 sometimes cited by analysts are more difficult to justify than some might suppose.