How do analysts use the PEG ratio to evaluate stock growth?

Analysts use the PEG ratio to evaluate whether a stock is fairly valued by comparing its Price-to-Earnings (P/E) ratio to its expected earnings growth. A PEG ratio helps analysts judge if a stock's price reflects its future growth potential. A lower PEG usually indicates undervaluation, while a higher PEG may suggest overvaluation relative to growth.

1. What Is the PEG Ratio?

The PEG ratio, or Price/Earnings to Growth ratio, is a valuation metric that combines the traditional P/E ratio with a company’s projected earnings growth rate. It is calculated using the formula:

PEG Ratio = P/E Ratio ÷ Annual EPS Growth Rate

This ratio allows analysts to see if a stock’s high P/E is justified by strong future growth or if it's overvalued.

For example:

If a company has a P/E of 20 and its earnings are expected to grow at 20% annually, then:

PEG = 20 / 20 = 1

A PEG of 1 is considered fairly valued. Below 1 is undervalued, and above 1 is overvalued (depending on the industry).

2. Why Do Analysts Use PEG Ratio?

The PEG ratio helps analysts go beyond the limitations of the P/E ratio. Here’s why it is widely used:

• Growth Adjustment: It adjusts for growth and provides a more complete picture.
• Fair Valuation: It helps in comparing stocks with different growth expectations.
• Relative Comparison: Useful in comparing companies across sectors with varying growth rates.
• Risk Insight: A very low PEG may mean growth is not sustainable or risks are underestimated.

3. Ideal PEG Ratio Range

As a rule of thumb:

• PEG < 1: Stock may be undervalued or expected to grow rapidly.
• PEG = 1: Fairly valued based on growth prospects.
• PEG > 1: Stock may be overvalued unless supported by other factors.

However, this range varies depending on the industry. Tech companies often carry higher PEGs due to rapid growth.

4. Limitations of PEG Ratio

While useful, the PEG ratio has limitations:

• Relies on Growth Estimates: Forecasted growth may not be accurate.
• Doesn’t Include Other Factors: Like dividends, risk profile, and macro conditions.
• Not Suitable for Negative Earnings: PEG doesn’t work well with companies that have negative EPS or growth.

5. PEG in Action: Real-World Example

Let’s assume two companies have the same P/E of 30:

• Company A expects 30% growth → PEG = 1.0
• Company B expects 15% growth → PEG = 2.0

Although both have the same P/E, Company A may be a better buy because its PEG is lower, suggesting more value for the expected growth.

6. PEG Ratio vs. P/E Ratio

Here’s how PEG differs from the basic P/E ratio:

Metric	P/E Ratio	PEG Ratio
Considers Growth	No	Yes
Fairer Valuation	Only partial	Yes
Best for Growth Stocks	No	Yes

PEG ratio plays a crucial role for analysts when evaluating stocks of fast-growing companies. It helps balance valuation with earnings growth to identify investment opportunities. While it should not be the sole metric used, combining PEG with other fundamentals like revenue growth, ROE, and debt can give a more comprehensive stock analysis.