Valuation Ratios: The PEG Ratio
by Joe Lan, CFA
In the past two articles in the Financial Statement Analysis series, I provided an introduction to valuation ratios and an analysis of the dividend discount model.
In this article, I continue my discussion of valuation metrics with the ratio of priceearnings to earnings growth, known as the PEG ratio.
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The PriceEarnings Ratio
The priceearnings ratio (P/E) is one of the most basic metrics of stock valuation. It is calculated by dividing a stock’s current price by its earnings, giving a relative valuation of a company based on its level of earnings per share. It allows investors to compare stocks with very different earnings per share on equal footing.
Though the priceearnings ratio may be the most widely used valuation ratio, there are glaring weaknesses in the figure. Perhaps most importantly, the priceearnings ratio fails to directly take into account an imperative characteristic of any stock—growth (or lack thereof). However, the priceearnings ratio is considered to be a measure of the market’s opinion of the company’s future prospects, which includes growth. From a pure priceearnings valuation standpoint, a stock with a priceearnings ratio of 10 is trading at a discount relative to a stock with a priceearnings ratio of 15. Still, investing in the lower priceearnings ratio stock may not be a prudent choice if the higher priceearnings ratio stock is growing twice as fast.
Consider the situation when the company trading with a priceearnings ratio of 10 is growing at 10% per year while the company trading with a priceearnings ratio of 15 is growing at 15% per year. Choosing the better investment gets much more difficult. When evaluating firms that are growing at significantly different rates or at high absolute rates, it is more practical to employ the PEG ratio to take into account growth rates. In addition, the PEG ratio can provide you with an idea of whether a highgrowth company is worth its rich priceearnings valuation.
The PEG ratio looks at earnings growth relative to the priceearnings ratio. Many investors use the PEG ratio to better differentiate stocks and to add a growth element to the basic priceearnings ratio.
The PEG Ratio
The PEG ratio is calculated by dividing a company’s priceearnings ratio by its growth rate in earnings per share:
PEG ratio = (current price ÷ earnings per share) ÷ earnings per share growth rate
There are also many variations of the PEG ratio, which are beneficial in different situations. I discuss several of them.
Historical PEG Ratio
Perhaps the simplest PEG ratio is the historical PEG, which divides current priceearnings ratio by the historical growth rate in earnings. It is up to the investor to choose the time frame for historical growth, but generally three to fiveyear periods are the norm. Table 1 uses data exported using AAII’s fundamental stock screener and research database Stock Investor Pro to calculate the historical PEG ratio of five major U.S. oil companies—ExxonMobil (XOM), Chevron Corp. (CVX), ConocoPhillips (COP), Valero Energy (VLO) and Marathon Oil (MRO). In the table, the historical PEG ratios are calculated using both threeyear and fiveyear historical earnings growth rates. I also use these same companies in subsequent examples.
As you can see from the table, the figures vary widely, ranging from 0.2 to 2.4 for the historical PEG using threeyear growth rates and 0.3 to 0.6 using fiveyear historical growth in earnings. Negative PEG ratios are not meaningful. PEG ratios are meaningful only if the company has a positive growth rate in earnings. The PEG ratio using a threeyear earnings growth figure returned two figures that are not meaningful, while the historical PEG using fiveyear growth in earnings returned three that are not meaningful.
P/E  Hist Growth  Hist PEG  
Ratio  3Yr  5Yr  3Yr  5Yr  
(X)  (%)  (%)  (X)  (X)  
ExxonMobil (XOM) 
13.8

5.8

3.2

2.4

4.3

Chevron Corp. (CVX) 
12.2

5.4

1.0

2.3

12.2

ConocoPhillips (COP) 
11.9

2.2

21.1

5.4

0.6

Valero Energy (VLO) 
10.5

45.2

33.6

0.2

0.3

Marathon Oil (MRO) 
16.0

5.2

13.9

3.1

1.2

Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014. 
While historical growth rates show companies’ short and longerterm historical performance, most investors are concerned with future earnings potential instead of past growth. This leads us to the next PEG variation—the forward PEG ratio.
Forward PEG Ratio
The forward PEG ratio compares the forward priceearnings ratio (current price divided by the consensus earnings per share estimate for the current fiscal year) to the estimated growth rate in earnings per share.
The rationale behind using this ratio is simple—stocks with a highexpected growth rate should trade with higher priceearnings ratios than stocks with low expectations for future earnings growth. Once again, there are several time frames that can be used for expected growth rate. AAII’s Stock Investor Pro provides an estimated threetofive year growth rate, but it is often difficult to forecast far into the future. At AAII, we also use another expected growth rate for some of our portfolios, one that measures the growth of earnings from the past fiscal year through the next two fiscal years. Table 2 presents the forward PEG ratios for the same five U.S. oil companies.
Similar to historical PEG ratios, forward PEG ratios also show a large variance. The forward PEG ratios using an average growth rate for the past fiscal year and the next two years (Y0 to Y2) range from 0.8 to 25.8 with one not meaningful number, while forward PEG ratios using an average earnings growth estimate for the next three to five years range from 0.6 to 3.6. Chevron’s 25.8 forward PEG ratio is an anomaly; figures this high are generally due to an abnormally low growth rate (it can also be due to an abnormally high priceearnings ratio based on low earnings, but this is less common). As you can see, Chevron is only expected to grow 0.4% over the next two years, leading to an abnormally high forward PEG ratio.
Forward  Earnings  Est Growth (%)  Forward PEG  
P/E  Y0  Y1  Y2  Y0 to Y2  35 Yr  Y0 to Y2  35 Yr  
(X)  ($)  ($)  ($)  (%)  (%)  (X)  (X)  
ExxonMobil (XOM)  13.2  7.41  7.71  7.68  1.8  3.7  7.3  3.6 
Chevron Corp. (CVX)  11.6  11.10  10.75  11.20  0.4  5.5  25.8  2.1 
ConocoPhillips (COP)  12.4  6.51  6.26  6.16  2.7  7.0  4.5  1.8 
Valero Energy (VLO)  8.5  5.33  6.56  6.43  9.8  14.6  0.9  0.6 
Marathon Oil (MRO)  11.9  2.26  3.01  2.97  14.6  4.4  0.8  2.7 
Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014. 
Adjusting for Dividends
Often, especially in value investing, there are large and highly profitable companies that return much of their earnings to shareholders in the form of cash dividends. These companies may be growing slowly and appear to be significantly overvalued. However, in addition to earnings growth driving share prices, shareholders get a sizable dividend on a regular basis. These dividends are a form of return and the normal PEG ratios do not take into account the dividend these companies pay, placing them at a disadvantage. In these cases, an adjustment can be made to the PEG ratio to “level the playing field” between these types of stocks and nondividendpaying stocks. The dividendadjusted PEG ratio is calculated as follows:
Dividendadjusted PEG ratio = priceearnings ratio ÷ (earnings growth rate + dividend yield)
Once again, there are two different dividendadjusted PEG ratios that are often used by investors. The historical dividendadjusted PEG uses the historical priceearnings ratio and earnings growth rate, while the forward PEG uses the forward priceearnings ratio and an estimated earnings growth rate. Table 3 presents both of these ratios for the same five oil companies.
Historical DividendAdjusted PEG Ratios  
Div  Hist Growth  Hist DivAdj PEG  
P/E  Yield  3Yr  5Yr  3Yr  5Yr  
(X)  (%)  (%)  (%)  (X)  (X)  
ExxonMobil (XOM)  13.8  2.7  5.8  3.2  1.6  27.6 
Chevron Corp. (CVX)  12.2  3.4  5.4  1.0  1.4  5.1 
ConocoPhillips (COP)  11.9  3.6  2.2  21.1  8.5  0.5 
Valero Energy (VLO)  10.5  1.8  45.2  33.6  0.2  0.3 
Marathon Oil (MRO)  16.0  2.1  5.2  13.9  5.2  1.4 
Forward DividendAdjusted PEG Ratios  
Forward  Div  Est Growth  Frwd DivAdj PEG  
P/E  Yield  Y0 to Y2  35 Yr  Y0 to Y2  35 Yr  
(X)  (%)  (%)  (%)  (X)  (X)  
ExxonMobil (XOM)  13.2  2.7  1.8  3.7  2.9  2.1 
Chevron Corp. (CVX)  11.6  3.4  0.4  5.5  3.0  1.3 
ConocoPhillips (COP)  12.4  3.6  2.7  7.0  14.2  1.2 
Valero Energy (VLO)  8.5  1.8  9.8  14.6  0.7  0.5 
Marathon Oil (MRO)  11.9  2.1  14.6  4.4  0.7  1.8 
Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014. 
For companies such as these, the dividendadjusted PEG ratios have numerous advantages. Investors who purchase these stocks are often looking for a yield to provide current income and stability. These five companies are large and mature and are unlikely to grow at a pace much faster than that of the overall economy. Incorporating the dividend yield into valuation allows investors to take into account the varying yields of these companies when using the PEG ratio for analysis.
The historical dividendadjusted PEG ratios using the threeyear earnings growth rate range from 0.2 to 8.5, with one figure that is not meaningful; using the fiveyear earnings growth rate the historical dividendadjusted PEG range is 0.3 to 5.1, with two not meaningful figures. As usual, the forward dividendadjusted PEG ratios are less skewed, ranging from 0.7 to 14.2 based on a twoyear estimated earnings growth rate and 0.5 to 2.1 based on a fiveyear estimated earnings growth rate.
Using the PEG Ratios
As is the case with most ratios used in investment analysis, making sense of the ratios in the real world is much more difficult than calculating them.
From an overall valuation standpoint, it looks like Valero Energy is trading with the lowest valuations based on the PEG ratios. The company has grown strongly over the last threeyear and fiveyear time frames and is expected to grow the quickest going forward. In addition, its priceearnings ratios (historical and forward) are the lowest out of the five.
However, you will almost immediately notice that Valero Energy’s dividend yield of 1.8% is the lowest out of the five companies. Investors often purchase large oil companies because of their stability and dividend yield, and investors may be hesitant to buy a major oil stock without the type of yield they expect. In addition, Valero’s expected three to fiveyear earnings growth rate is significantly higher than any other oil company, leading to its much lower forward dividendadjusted PEG ratio. A prudent investor would ask whether such a high growth rate in the intermediate future is appropriate given the tempered expectations of the rest of the companies.
Caveats
The PEG ratio has often been used to value companies with high levels of growth (though our examples used slowergrowing companies). One of the reasons for its use was for analysts and investors to make an educated guess as to whether a fastgrowing company deserves a high priceearnings ratio. This ratio, and even the dividendadjusted PEG ratio, may not be appropriate for large, mature companies that pay a large portion of earnings out in the form of dividends.
The PEG calculation also uses earnings per share growth rates. The historical growth rate is easy enough to calculate with accuracy, but the growth estimate depends on analysts and these figures can be highly inaccurate or hard to find.
In addition, there is no consensus on the time frame that should be used. Appropriate time frames will be different for cyclical and noncyclical companies.
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