The PEG Ratio: Growth at a Reasonable Price

"The price-to-earnings ratio of any fairly priced company will equal its growth rate. If the PEG is less than one, you may have found a bargain." — Peter Lynch

Peter Lynch's most practical contribution is the PEG ratio:

PEG = price-to-earnings ratio ÷ earnings growth rate.

A company growing at 20% a year on a multiple of 20 times earnings has a PEG of 1.0 — roughly fairly valued. At 12 times earnings, its PEG is 0.6, which may be cheap. At 35 times, its PEG is 1.75, meaning you are paying a premium for the growth.

The power of PEG is that it reconciles value and growth in one number. A "cheap" stock at 8 times earnings growing at 3% a year (PEG around 2.7) is actually far more expensive than a "pricey" stock at 25 times earnings growing at 30% (PEG around 0.8). As a rough guide, a PEG below 0.5 is unusually cheap, 0.5 to 1.0 attractive, and above 2.0 a sign that growth is already priced for perfection. Like any single ratio, it is a screen, not a conclusion — growth forecasts can be wrong.

Illustrative example: the discipline in practice

Lynch ran one of the most successful funds of its era over more than a decade by applying this growth-at-a-reasonable-price discipline across hundreds of stocks — consistently declining to overpay for growth, rather than by making one or two spectacular calls.