# Understanding the PEG ratio

##### The PEG ratio assesses companies having different growth rates and gives a better picture of which company is more expensive

If there are two identical companies which are similar in every regard except that one company is projected to grow at a higher rate than the other, then isn't it natural for a rational investor to pay more for the high-growth company?

This analogy underscores an important shortcoming of the P/E metric i.e it ignores expected growth rates. The P/E ratio values all companies based only on its historical earnings and this is inappropriate for comparing companies which are in different stages of their life cycles. If two companies have the same P/E ratio, it is likely that many people will reach a very cursory (but incorrect) conclusion that both these companies are trading at the same relative valuation. But we know that a declining company is not likely to repeat its earnings, while the company in its growth phase is likely to increase its earnings in the future.

To rectify this shortcoming of the P/E ratio, the PEG or 'price-earnings to growth' ratio was devised. This metric adjusts a company's P/E by dividing the P/E with the company's expected growth rate. In a sense, the metric tells us what the P/E is per unit of expected growth. For example, a company trading at a P/E of 15 and having an expected earnings growth of 20 per cent would have a PEG of 0.75.

If a company has a higher PEG ratio, it means that even after accounting for its expected growth, it is more expensive than the one with a lower PEG. So, when used for companies having different growth rates, the PEG ratio gives a better picture of which company is more expensive. The generally accepted thumb rule is that a PEG of 1 implies that a company is fairly valued. Anything less than that is considered to be undervalued and vice versa.