Price to Earnings Growth Multiple (PEG)

The PEG multiple takes the P/E analysis to the next stage. Since P/E ratios are computed based on historic earnings, they project an inaccurate picture of the future. The PEG multiple uses expected growth in earnings, to give investors additional information.

The PEG divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the compounded earnings growth is calculated using the forecasted earnings for the next two-three years.

For example, if a company is quoting at a P/E of 60 based on historic earnings and the compounded annual growth rate of its earnings for the next three years is 20 per cent, then its PEG is 3.

The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a stock on a multiple of 50 whose earnings are growing at 20 per cent.

As a thumb rule, stocks quoting at a PEG multiple below 0.5 are considered to be undervalued, 1 to be fairly valued, and 2 to be overvalued.