What’s a Good PEG Ratio? It Depends. Simple Pitfalls to Avoid

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!

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).

Figuring out that growth part can be tricky though.

Finding a good, realistic estimate for growth makes conventional wisdom about what a good PEG ratio is a bit murky.

We will cover the basics of the PEG and simple pitfalls to keep in mind when determining what you define as a “good” PEG ratio.

The Basics of the PEG Formula

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.

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.

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.

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= $157.78

Easy enough, we have the “Price” part of the P/E. Next we’ll pull up the company’s EPS (TTM, or Trailing Twelve Months), which you can find in the Financials tab of a great free website for stock market KPIs called Stratosphere.io.

With those numbers in hand, we can calculate the company’s P/E ratio today:

  • Price = $157.78
  • EPS = $6.05
  • P/E = 157.78 / 6.05
  • P/E = 26.1

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.

Moving to the financial Statements tab, we can make that calculation as follows:

  • 2021 EPS = $5.61
  • 2020 EPS = $3.28
  • EPS YOY = (5.61 / 3.28) – 1
  • EPS YOY = 71.0%

Finally, plug the two inputs, our P/E and EPS Growth, into the PEG formula as so:

  • PEG = (P/E) / Growth
  • PEG = 26.1/ 71.0
  • PEG = 0.37

Is this a good PEG ratio for Apple?

Realistically, the huge growth rate in EPS from 2020 to 2021 should not be expected to be the norm for a company over the long term. Better yet would be to make an adjustment to find a more reasonable growth rate.

Making Better Growth Estimates

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, say Apple just released a brand new iPhone that was a blockbuster hit. Say the next year the company had no new phone releases; that next year after the blockbuster would show little growth. Some business models see this kind of phenomenon more than others.

Going back to our example one more time, let’s take the average of 3 YOY growth rates for Apple:

  • 2021 EPS = $5.61
  • 2020 EPS = $3.28
  • EPS YOY= 71.0%
  • 2020 EPS = $3.28
  • 2019 EPS = $2.97
  • EPS YOY= 10.4%
  • 2019 EPS = $2.97
  • 2018 EPS = $2.98
  • EPS YOY = -0.3%
  • 3-year avg growth = 27.0%

Is this a better growth estimate?

Maybe… it’s still very high but at least is averaged out over several years to account for fluctuations from year to year. The updated PEG for Apple in this case would be 0.97 rather than 0.37.

Potential Pitfalls of the PEG 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, I went back through 20 years of financial data for 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.

More Evidence About the Pitfalls of the PEG Ratio

Famed investment strategist Michael Mauboussin wrote a fantastic report called “The Base Rate Book.” It included groundbreaking research on historical growth rates.

I wrote an entire blog post to try and summarize his findings. 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.

For example, say 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. It’s clear that 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.

Investor Takeaway

I hope that all of this data wasn’t discouraging and didn’t feel like a firehose 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 is 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 this information better directs the performance of the stocks you choose to buy, based on how you project their future growth.

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