PEG ratio

A P/E of 40 is not automatically expensive and a P/E of 10 is not automatically cheap. A company growing earnings at 35% a year deserves a higher rating than one growing at 5%, and the whole problem is deciding how much higher.

The PEG ratio settles it arithmetically: divide the P/E by the growth rate. The number that comes out is what the investor pays for each unit of growth, and it makes two companies with very different P/Es directly comparable.

Peter Lynch, who coined the measure, argued that a PEG below 1 suggests the business may be undervalued, and a PEG above 1 suggests the opposite. The workbook reproduces the first half of that rule; the sentence giving the other half is damaged in print and reads "A stock with a PE ratio is seen as overvalued", with the word "PEG" and the comparison lost. The intended reading is a PEG above 1.

Lynch attached a warning to his own rule and the workbook repeats it: a high growth regime may not continue for very long, and the investor should be cautious of assuming it will. The growth rate in the denominator is a forecast, and it is doing all the work.

The workbook's own guidance is to treat the threshold of 1 as a rule of thumb that will not suit every circumstance, and to compare PEG across companies rather than against an absolute benchmark.

            Price ÷ Earnings per share        P/E
PEG = ──────────────────────────────── = ──────────
              Growth rate (%)              Growth

The growth rate goes in as a whole number: a P/E of 40 and growth of 32% gives 40 ÷ 32 = 1.25, not 40 ÷ 0.32.

Two FMCG companies:

On P/E, Staple looks half the price of Nutri. On PEG, Nutri is the cheaper of the two — the investor pays 1.25 for a unit of growth against 1.82.

Now apply Lynch's warning. Nutri's 32% has to hold. Suppose growth settles at 15% instead. Its PEG jumps to 40 ÷ 15 = 2.67, and for the PEG to return to 1.25 the P/E must fall to 18.75× — a price of Rs 450. That is a 53% fall in the share price while earnings are still growing at 15% a year.

The workbook's own sample question in Chapter 10 does the same arithmetic on two companies: Company A's EPS moves 17.0 to 19.5 (14.7% growth) at a P/E of 15.4×, giving a PEG of 1.05; Company B's EPS moves 26.8 to 32.2 (20.1% growth) at 18.2×, giving 0.91. The higher P/E company is the cheaper one.

Chapter 10 (section 10.7.3) defines the PEG ratio and works the A Ltd / B Ltd example, and the chapter's sample questions return to it with a two-company table asking which is cheaper on PEG using the forecast growth rate. Expect a straight computation and the "PEG below 1 may be undervalued" statement.

• Put growth in as a whole number. Dividing by 0.32 instead of 32 gives 125 instead of 1.25 and every answer option will look wrong.
• PEG is meaningless for zero or negative growth. A negative growth rate produces a negative PEG that looks temptingly "below 1".
• The workbook's overvaluation sentence is damaged in print (Chapter 10.7.3). The rule is PEG below 1 may be undervalued, above 1 overvalued.
• State the growth period. The workbook's sample question specifies "use the expected growth rate for 2XX9" — change the period and the answer changes.
• PEG inherits P/E's blind spot. Both are equity multiples, so leverage distorts them; Chapter 10.7.4 sends an acquirer to EV/EBITDA instead.
• A rule of thumb is not a valuation. The workbook says so directly: compare PEG across competitors rather than trusting the threshold of 1.