The price-to-earnings (P/E) ratio is one of the most common metrics for valuing a stock. However, this ratio considers only the static earnings and not the earnings growth over a period.
This means that two companies with the same earnings may appear equally valued under the P/E ratio, even if one’s profit is growing 20% annually while the other is growing at just 5%.
This is where the price-to-earnings-to-growth (PEG) ratio becomes useful. By incorporating earnings growth, the provides a more comprehensive view of whether a stock is fairly valued relative to its earnings growth.
So, let’s explore what the PEG ratio is, how it differs from the P/E ratio, and how you can value a stock using the PEG ratio.
What is the PEG ratio?
While the P/E ratio measures how much an investor is willing to pay for ₹1 of a company’s earnings, the PEG ratio measures how much an investor is willing to pay for every 1% of earnings per share () growth.
The PEG ratio is calculated by dividing a stock’s P/E ratio by its earnings per share (EPS) growth rate over a specified period, such as a quarter or a financial year.
PEG Ratio = (Price/ EPS)/ EPS Growth
A PEG ratio can be classified as a trailing PEG ratio when it uses historical EPS growth rates. If it is based on projected or expected EPS growth rates, then it is called a forward PEG ratio.
A practical example of PEG ratio vs P/E ratio
Suppose there are two healthcare companies, X and Y. Here are the details of these two companies.
Company X is trading at a share price of ₹50. Its EPS in FY26 is ₹3, and its EPS growth is 30% over FY25.
Company Y is trading at a share price of ₹80. Its EPS in FY26 is ₹4, and its EPS growth is 50%.
| Particulars | Company X | Company Y |
| Share Price | ₹50 | ₹80 |
| EPS (FY26) | ₹3 | ₹4 |
| EPS Growth (FY26 – FY25) | 30% | 50% |
| P/E Ratio (Price ÷ EPS) | 16.66 | 20 |
| PEG Ratio (P/E ÷ EPS Growth) | 0.55 | 0.40 |
Let’s first calculate the P/E ratio of both stocks.
- P/E Ratio = Share Price ÷ EPS
- Company X = 50 ÷ 3 = 16.66
- Company Y = 80 ÷ 4 = 20
Based on the P/E ratio, Company X appears to be cheaper because it has a lower P/E ratio than Company Y. However, the P/E ratio does not consider the earnings growth of a company.
Let’s see what the PEG ratio indicates.
- PEG Ratio = P/E Ratio ÷ EPS Growth Rate
- Company X = 16.66 ÷ 30 = 0.55
- Company Y = 20 ÷ 50 = 0.40
Now, the PEG ratio indicates that Company Y offers better value relative to its growth prospects. This shows how the PEG ratio can provide a better analysis of a stock’s valuation by considering both earnings and earnings growth.
What is considered to be an ideal PEG ratio?
A PEG ratio of less than 1 is generally considered attractive because it suggests that you are paying less for every 1% of earnings growth. On the other hand, a PEG ratio above 2 may indicate that a stock is overvalued.
However, there is no ideal benchmark for the PEG ratio, as it can vary across industries. Therefore, it is better to compare PEG ratios within the same sector or industry to identify the most fairly valued stock.
While the P/E ratio is one of the simplest ways to identify , the PEG ratio adds another layer by incorporating earnings growth. Hence, using both metrics together can provide a more comprehensive view of a stock’s valuation.
Limitations of using PE and PEG ratios for stock valuation
One of the basic points is that the P/E and PEG ratios are not very relevant when a company’s earnings or growth are negative. In such cases, the Price-to-book (P/B) value, Price-to-Sales (P/S) ratio, or EV/EBITDA are considered as a better option.
However, one lesser-known limitation is that these ratios cannot be used to analyze stock valuation across all sectors.
Not relevant for banks and financial institutions
Banks and financial institutions keep provisions for bad loans, which reduce their reported profits in the books. As a result, earnings may appear lower than their actual earning capacity, thereby making P/E and PEG ratios appear artificially high.
Misleading for cyclical sectors
Cyclical sectors such as oil and gas, mining, and cement experience significant fluctuations in earnings due to changes in commodity prices and economic conditions. As a result, a low or high P/E and PEG ratio may reflect temporary swings in profitability rather than the company’s true value.
Inaccurate measure for real estate
Real estate companies own large property assets and mark high depreciation expenses in their books, which reduces their reported profits. As a result, P/E and PEG ratios often appear unusually high. Also, these ratios do not consider cash flow growth, which is the most important factor to analyse in real estate.
Hence, the PE and PEG ratios work best in sectors with a clear revenue model that are not affected by economic cycles or accounting practices. These include FMCG, retail, chemicals, IT, healthcare and pharmaceuticals.
Disclaimer: This is purely for educational/ informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.