Understanding the PEG Ratio

Abstract

The price-earnings-to-growth, or PEG, ratio is widely used by both individual investors and professional portfolio managers. This article explores the relationship between the PEG ratio and its determinants. The main conclusions are that (1) higher PEG ratios are consistent with correct valuation for firms with relatively low growth, for firms with more persistent high growth, and for firms with low cost of capital, and (2) PEG ratios frequently should exceed the conventional 1.0 benchmark for correctly valued firms, especially those with low cost of capital. The article recommends against using PEG as a tool to choose among different types of firms and concludes that the best use of PEG is for within-industry screening when firms are likely to have similar cost of capital and similar growth prospects