Most Valuation Metrics Lie to You
The P/E ratio is the most famous valuation tool in investing. Price divided by earnings. Simple.
But it has a fatal flaw: it ignores growth.
A company with a P/E of 30 sounds expensive. But what if it’s growing earnings at 40% per year? Suddenly 30 looks cheap.
A company with a P/E of 8 sounds like a bargain. But what if earnings are shrinking? That “cheap” stock might be a value trap.
The PEG ratio fixes this problem.
What is the PEG Ratio?
PEG stands for Price/Earnings to Growth.
The formula is simple:
PEG = P/E Ratio ÷ Annual Earnings Growth Rate
Example: a stock has a P/E of 20 and earnings are growing at 20% per year. PEG = 20 ÷ 20 = 1.0.
Another stock has a P/E of 10 but earnings are only growing at 5% per year. PEG = 10 ÷ 5 = 2.0.
The first stock looks more expensive by P/E. But by PEG, it’s actually cheaper relative to its growth.
How to Read the PEG Ratio
- Below 1.0 — potentially undervalued. You’re paying less than the growth justifies.
- 1.0 — fair value. You’re paying exactly what the growth is worth.
- 1.0 to 1.5 — slightly expensive but often acceptable for high-quality companies.
- Above 2.0 — expensive. The stock needs to keep growing fast just to justify the current price.
These are guidelines, not rules. Context always matters.
Real World Example
Let’s look at two hypothetical companies:
Company A — Korean semiconductor manufacturer
- P/E: 12
- Earnings growth: 25% per year
- PEG: 0.48 ✅ Potentially undervalued
Company B — U.S. software company
- P/E: 45
- Earnings growth: 20% per year
- PEG: 2.25 ❌ Expensive
Company B is a better-known, more glamorous business. But Company A offers more value relative to its growth. A GARP investor buys Company A.
Limitations of the PEG Ratio
No metric is perfect. A few things to watch out for:
Growth estimates can be wrong. PEG uses future earnings growth, which is a forecast. If the company misses its growth targets, the PEG you calculated is meaningless.
It doesn’t account for debt. A company with a great PEG but massive debt is still risky. Always check the balance sheet.
It works better for growth companies. For slow-growing industries like utilities or real estate, PEG is less useful. Those sectors have their own valuation tools.
Different sources use different growth rates. Some calculate PEG using historical growth, others use forward estimates. Make sure you’re comparing apples to apples.
Why I Use PEG Across Both Markets
The beauty of the PEG ratio is that it works as a universal language.
Korean stocks tend to have low P/E ratios. U.S. stocks tend to have high growth rates. Without PEG, it’s hard to compare them directly.
With PEG, I can look at a Korean manufacturer and a U.S. tech company side by side and ask the same question: am I getting enough growth for what I’m paying?
That’s the question at the heart of every investment decision I make.