The PEG, also sometimes called the Fool ratio though The Motley Fool was probably not the first to define it, is a very quick and dirty, and likely inaccurate, measurement of how the price of a company relates to its current earnings and potential growth rate. Depending on which P/E ratio is used (trailing, current year, forward), one can get different results, as forward P/E is usually lower than trailing due to usually expected growth in earnings in the future.
How to Use the PEG Ratio
A PEG of less than 1 is generally considered desirable. For instance, if a stock's P/E is 20, and its projected growth rate is 25%, its PEG is 0.80. This is better than a stock with a P/E of 25 and a projected growth rate of 20, which would result in a PEG of 1.25. If the fact that 0.80 x 1.25 = 1 feels like a blanket fresh from the dryer, you are a math buff.
PEG Ratio Caveats
Because the PEG ratio depends on two numbers which are not entirely reliable (earnings or net income, which is an accounting number under GAAP and is not equal to cash coming into the company) and expected growth by analysts, the PEG is not a hard, reliable number. Because of this, the PEG should not be the sole basis of your investment decision.
Other limitations exist. Among these are:
- It ignores risk.
- A five-year estimate is really pushing it.
- It does not account for dividends, a not insubstantial contributor to total returns.
- It punishes low-growth stocks.
- Sample sizes vary. What if the expected growth rate is from only one or two analysts, compared to an average estimate from a dozen or more?
- It usually looks both ways, into the past with trailing P/E and into the future with growth expectations.
David Gardner Explains