Conventional wisdom says that a good PEG ratio is anything below 1. But actually, there’s a lot that can go wrong with that assumption, especially if the inputs for your PEG are unrealistic.
The PEG ratio was one popularized by the famed fund manager Peter Lynch, who went on to post one of the best mutual fund track records of all-time in less than two decades.
Lynch used the PEG to identify good growth stocks trading at reasonable prices.
The formula for the PEG ratio is:
PEG = Price to Earnings / Growth
Where Price to Earnings = Price / Earnings.
The PEG ratio is a shortcut for determining how cheap a stock is relative to its growth. The lower the PEG, the cheaper a stock is trading (relative to its earnings and growth in earnings).
Generally, any PEG below 1 is considered very good. This means you’re getting a discount on the company compared to its growth rate. You can think of a PEG of 1 as fair value. There’s no discount, but no premium (in price paid) for the growth of that stock.
A PEG around 1.5 is where a stock can start to be considered more expensive, and generally one above 2 is considered expensive.
Figuring out that growth part can be tricky though, and a good realistic estimate makes conventional wisdom about what a good PEG ratio is kinda murky.
We’ll cover that more below, but first let’s talk about why the PEG ratio can be very useful, for several reasons.
Reason #1: Stock Prices Follow Earnings Growth
Earnings per Share (EPS) represent how much of a company’s profits each share has a claim to. Shares represent part ownership of a business, and the total number of shares (shares outstanding) represent the entire ownership stake.
A company’s total earnings are attributable to the entire ownership stake; each share’s stake is represented by EPS.
As EPS grows, so does the value of each share.
This growth in EPS drives the growth in share price over the very long term.
Naturally, stocks with higher EPS growth are more valuable than those with lower EPS growth. And so, higher growth stocks deserve higher prices, which are represented by valuation “multiples”, most commonly the P/E (price to earnings) multiple.
The downside to higher growth stocks is that they do not grow forever. Growth is not always constant; sometimes it slows down.
When investors get overly excited about a stock, they may attach a much higher multiple to it, which causes the stock price to fall if expectations are not met.
The PEG ratio attempts to mitigate this risk through its calculation; stocks that are trading at multiples much higher than their growth rates will be flagged with a high PEG.
On the flip side, stocks that are trading at cheap discounts to their earnings and earnings growth rates will show a good PEG ratio.
Reason #2: The PEG is a Good Indicator of Market Sentiment
Prices in the stock market can swing to extremes, and therefore create both very high PEG and P/E and very low PEG and P/E multiples.
This is because the stock market is a very emotional place—known as “Mr. Market” by practicing value investors.
The nature of markets are cycles which behave similarly to economic cycles. Economic cycles flow through periods of expansion and contraction. You have boom and bust, bear and bull markets which follow the laws of nature (and human behavior). Humans spend and lend freely, then they overspend, and then they pull back as they lick their wounds.
Even if this doesn’t happen with every individual, it happens in the overall economy, as businesses spend and invest and then pull back as appropriate.
Since the economy is so interconnected, the behaviors of the crowd lead to a chain reaction, further reinforcing the contractionary and expansionary cycles. In other words, the market goes through cycles of greed and fear.
The PEG ratio can be a nice way to “check” the emotions of the market, by placing a numerical context to the prices in the market.
How to Calculate the PEG Ratio Example: $AAPL
Let’s take a look at Apple’s ($AAPL) latest financials, and I’ll show you how to use that information to estimate its PEG ratio.
Remember that to calculate the PEG, we’ll need:
- The P/E ratio
- Earnings Growth
To keep things apples-to-apples, we’ll use “per share” values, in other words we’ll calculate the P/E using Earnings Per Share and the earnings growth by the same Earnings Per Share.
First, I’ll check our handy Google friend to see where Apple ($AAPL) is trading at today.
- Share price= $125.23
Easy enough, we have the “Price” part of the P/E. Next we’ll pull up the company’s EPS, which you can find on the Income Statement of the company’s latest annual report (10-k).
I recommend using diluted EPS instead of basic EPS because it is a more conservative (and accurate) measure.
With those numbers in hand, we can calculate the company’s P/E ratio today:
- Price = $125.23
- EPS = $3.28
- P/E = 125.23 / 3.28
- P/E = 38.2
Next, we need to calculate the (G) of PEG, the growth. The simplest way would be to look at the company’s YOY (year over year) growth in EPS.
Referencing that same screenshot above, we can make that calculation as follows:
- 2020 EPS = $3.28
- 2019 EPS = $2.97
- EPS YOY = (3.28 / 2.97) – 1
- EPS YOY = 10.4%
Finally, plug the two inputs, our P/E and EPS Growth, into the PEG formula as so:
- PEG = (P/E) / Growth
- PEG = 38.2/10.4
- PEG = 3.67
Is this a good PEG ratio for Apple?
Realistically, a PEG above 3 is pretty high and indicates that the stock will probably fall if it can’t maintain (or even improve) its current level of growth.
Making Better Growth Estimates
Note that a more accurate way to calculate the PEG ratio for a company is by averaging multiple years of growth instead of using just one YOY value.
This is because earnings (and EPS) can fluctuate wildly from year-to-year, which isn’t necessarily a bad thing. It’s just the nature of businesses.
For example, if Apple just released a brand new iPhone that was a blockbuster hit, and then the next year had no new phone releases, then the year after the blockbuster would show little growth. But if the company naturally grew in this regular pattern of blockbuster releases, as an example, then they would actually be growing very well long term even if they didn’t grow so much this past year.
Going back to our example one more time, let’s take the average of 2 YOY growth rates for Apple:
- 2020 EPS = $3.28
- 2019 EPS = $2.97
- EPS YOY= 10.4%
- 2019 EPS = $2.97
- 2018 EPS = $2.98
- EPS YOY = -0.3%
- 2-year avg growth = 5.2%
As I wrote in my article about a version of the PEG ratio I call “The Safety 1st PEG”, I recommend taking an average of at least 3 years of YOY growth to get a better estimate on how much growth a company is truly achieving over the long term.
Potential Pitfalls of the PEG Ratio
You have to be careful about not blindly looking at a PEG ratio below 1 and automatically assuming that that’s a good PEG ratio.
As I mentioned above, a company’s earnings growth can be misrepresented from one year to the next.
These earnings fluctuations can also affect the P/E portion of the PEG ratio, since a one-time, temporary boost to EPS would increase the “Earnings” part of the P/E and distort the ratio.
One pitfall which I don’t see talked about at all, is that higher growth rates are actually pretty rare in the stock market.
To prove this to you, (back in December) I went back through 20 years of financial data for the current S&P 500 constituents and looked at their YOY growth in EPS.
Then I took the MEDIAN of these YOY growth numbers (this is better than taking an average because it weeds out the extremes, high and low).
Here’s what I found:
- 52% of companies had a median YOY EPS Growth of 5%+
- 30% of companies had a median YOY EPS Growth of 10%+
- 13% of companies had a median YOY EPS Growth of 15%+
- 5% of companies had a median YOY EPS Growth of 20%+
- 2% of companies had a median YOY EPS Growth of 25%+
- 1% of companies had a median YOY EPS Growth of 30%+
In other words, you have a 50-50 shot of picking a company with consistent EPS growth of only 5% or greater. That’s not very good.
Consider that the number of stocks that trade at a P/E ratio of around 5 is pretty slim, and so you have a 50-50 chance of being wrong in thinking you have a good (accurate) PEG ratio if your PEG is under 1 and yet you’re paying more than a 5x P/E.
On the other end of the spectrum, it’s incredible to me that only 2% of the S&P 500 companies had a median EPS growth rate of 25%+.
This means that if you think you have a good PEG ratio because your company’s P/E is 25 and their growth is 25, you’re probably wrong. Actually, only 2% of companies have been able to sustain that!
What looks to be more realistic, based on these probabilities, are growth rate estimates somewhere between 5%-10%.
And using what we know about the stock market, over the very long term the P/E ratio has been around 15-17.
And so, it might be more realistic to say that you’ll probably have to pay a PEG of around 1.5- 3.0, at least if you’re being honest about the company’s true long term growth.
Most importantly: be wary of any PEG calculation which involves a growth rate above 20% or more.
You’re starting to encroach on those businesses of which few have actually achieved such superior performance.
Instead adjust your PEG ratios upwards by being realistic in estimating the growth side of the equation.
More Evidence About Good Growth Estimates
Famed investment strategist Michael Mauboussin wrote a fantastic report he called “The Base Rate Book”, where he unloaded groundbreaking research on historical growth rates.
I wrote an entire blog post to try and summarize his findings, and I highly recommend reading both the post and his book to really internalize the lessons.
But basically, it came down to the fact that for most companies, their past growth did NOT prove to be a great indicator for future growth.
After sifting through 65 years of data, Mauboussin found that there was more luck involved (“reversion to the mean”) than skill when it came to future revenue growth rates.
This has profound implications on EPS growth rates, since EPS growth follows revenue growth over the long term.
This has profound implications on our PEG ratio as well.
Go back to our example of calculating the PEG ratio above. Notice how we used past historical growth rates, which is fine as a shortcut because that’s the definition of calculating growth.
But we now have this information about historical growth rates not being great predictors of the future.
Maybe we should combine Mauboussin’s findings with my own probabilities dataset.
If growth reverts to the mean, then maybe it makes more sense to adjust the “growth” of PEG when it falls out in the extremes of probability.
For example, if I’m looking at a stock that’s had 20% EPS growth over the long term, maybe I doubt that the company can really maintain that kind of a growth rate to stay in the top 5% of S&P 500 companies historically.
Maybe it makes more sense to input 15% growth for the PEG ratio, even though the company did earn 20% growth, because the odds are against them continuing such a fantastic streak.
In that way, we’ll have a more realistic estimate for growth, and thus a better calculation for our PEG ratio and if it really indicates a potentially undervalued stock or not.
I hope that all of this data wasn’t discouraging and didn’t feel like a firehouse of information. If it did, take it slow and read through some of our other great resources on the PEG ratio, and those I’ve previously linked in this article.
The point I am trying to make is that metrics like the PEG are only as good as our understanding of them.
And one of the mistakes that I made when I was starting out was to take some of these ratios too literally, without providing thought into what they are truly indicating.
Numbers in the stock market are a great guide, but if we don’t understand them we’ll be blind to times when they lead us astray.
Defining a good PEG ratio is one of those times.
Because growth a primary input in the formula, you have to be careful about how you are calculating it, especially with all of the variants out there on the internet today.
Hopefully with some of these findings you’ve gotten a better grasp on what’s possible with EPS growth, and that it better directs the performance of the stocks you choose to buy based on how you project their future growth.