PEG and growth-adjusted multiples
A high P/E on fast growth can be cheaper than a low P/E on none. The PEG ratio puts the two on the same footing.
- Calculate the forward P/E and the PEG ratio
- Find the P/E and share price that a target PEG implies
- Back out the growth a share price assumes
- Show how a stock grows into its multiple
The intuition
Two apple trees cost the same. One gives 100 apples a year and always will; the other gives 50 now but its harvest grows fast every year. The price per apple today says little about which is the better buy until you know how fast each harvest grows.
P/E is the price for each dollar of earnings today. The PEG ratio divides it by the growth rate written as a whole number, so a stock on 30x earnings growing 30% a year and one on 10x growing 10% both have a PEG of 1.0.
Forward P/E = price ÷ (EPS × (1 + growth)). PEG = P/E ÷ (growth × 100). P/E for a target PEG = target PEG × growth × 100. Growth implied by a PEG = P/E ÷ (PEG × 100).
Why it works
- The conventions here: PEG uses the trailing P/E (on last year's EPS) and the expected annual EPS growth, with no adjustment for dividends. The forward P/E uses next year's EPS.
- The rule of thumb: below 1 looks cheap, 1 to 2 looks fair, above 2 looks dear. It is a screen, not a valuation.
- On the same P/E, the faster grower has the lower PEG. Growth is the only thing that differs.
- Running it backwards is the useful part: a P/E and a 'fair' PEG give the growth the price assumes, which you can set against what analysts expect.
- Stocks grow into their multiples. If the price does not move, the P/E falls by a factor of (1 + growth) each year, which is how a high-PEG stock justifies itself, if the growth arrives.
- PEG ignores how long the growth lasts, how risky it is and how much cash comes back, so a low PEG on a one-year bounce is a trap.
| EPS: 60 ÷ 30 | $2.00 |
| Forward P/E: 60 ÷ (2.00 × 1.20) | 25.0x |
| PEG: 30 ÷ 20 | 1.50 |
| P/E at a PEG of 1.25: 1.25 × 20 | 25.0x, a $50.00 price |
| Growth a PEG of 1.25 implies: 30 ÷ 125 | 24% |
| P/E after 3 years at a flat price: 30 ÷ 1.20³ | 17.4x |
Another stock on 30x growing 10% has a PEG of 3.0: the same P/E, twice the price for its growth.
The formulas
The price on next year's earnings.
Points of P/E per point of growth.
What a fair PEG allows.
Run it backwards.
Growing into the multiple.
Worked example
Trailing EPS from the price and the P/E, grow it one year for the forward P/E, then divide the P/E by the growth rate.
See it move
Same company. Change the P/E, the expected growth, the PEG the market calls fair and the share price.
- Raise the P/E. The PEG and the growth it implies rise; the P/E at the fair PEG does not move.
- Raise growth. The PEG and the forward P/E fall, and the P/E the fair PEG allows rises.
- Raise the fair PEG. The P/E it allows rises and the growth the price implies falls.
- Change the share price. The PEG does not move: it depends only on the P/E and growth.
Run it backwards
Same company, reversed: the sector trades on a set PEG. What growth is this share price assuming?
Rearrange PEG = P/E ÷ growth: growth = P/E ÷ PEG, then divide by 100 to turn it back into a rate.
If the implied growth is above what analysts expect, the price needs more than consensus to be fair, which is where a short thesis starts. If it is below, the long thesis writes itself, provided you believe the estimates.
Traps
Say it in the interview
“How do you compare the valuation of a fast-growing company with a slow-growing one?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- PEG = P/E ÷ (growth × 100).
- Growth implied = P/E ÷ (PEG × 100).
- Same P/E, faster growth, lower PEG.
- At a flat price the P/E falls by (1 + growth) a year.