Two companies both trade at 30 times earnings. One is growing 30% a year, the other 10%. On a P/E screen they look identical. They are not remotely the same price.
That gap is what the PEG ratio exists to close, and it's the valuation measure I lean on hardest.
What the PEG ratio means, and why P/E alone isn't enough
The price-to-earnings ratio divides the stock price by earnings per share. A $60 stock earning $4 a share trades at 15 times earnings, which is another way of saying investors are paying $15 for every $1 of annual profit.
Useful. Not sufficient. A company compounding earnings at 30% a year deserves to cost more per dollar of current profit than one creeping along at 3%, because you aren't buying this year's earnings. You're buying the stream.
Judge both companies against the same multiple and you systematically penalize exactly the businesses a growth investor is trying to find. I'm primarily a growth investor. Value names have a real place in my portfolios, but as a diversifying sleeve rather than the core. For that approach, P/E as a standalone signal is close to useless.
The PEG ratio formula
One convention to get right before you divide: enter the growth rate as a whole number. Thirty percent growth goes in as 30, not as 0.30. Get that wrong and your PEG comes out a hundred times too large, which is a mistake people make exactly once.
Back to the two companies.
| Company A | Company B | |
|---|---|---|
| P/E ratio | 30 | 30 |
| Expected earnings growth | 30% | 10% |
| PEG | 1.0 | 3.0 |
Same P/E. One is paying a fair price for growth and the other is paying three times over for it. That single division is the whole discipline.
What is a good PEG ratio, and where the thresholds came from
The convention traces back to Peter Lynch. A PEG below 1.0 reads as inexpensive relative to growth. A PEG above 2.0 says a great deal of expected growth is already sitting in the price.
Lynch took over Fidelity's Magellan Fund in 1977 running about $18 million. By the time he stepped down in 1990 it was roughly $14 billion, compounded at an annualized 29.2%, more than double the S&P 500 over the same stretch. He laid the approach out in full in One Up on Wall Street in 1989. The idea the write-ups kept returning to was the one that stuck with me: don't ask whether a P/E looks high, ask whether it looks high relative to how fast the business is actually growing.
I started using PEG in the mid-1980s, before most investors would have recognized the name, after reading interviews with Lynch and the coverage of what he was doing at Magellan.
An honest adjustment, forty years on
Here's something I'd rather say plainly than leave you to discover.
We quite often buy stocks with PEG ratios near 2. That isn't a failure of discipline. It's adapting a system built in the 1980s to how the market prices growth now.
Below 1.0 and above 2.0 are my working reference points, not laws. The market has spent four decades rerating growth, and a rule that would have kept you out of almost every quality compounder since 2010 isn't a rule worth keeping unchanged. What survives from Lynch is the question, not the cutoff: is the price sensible relative to what this business can actually produce?
Treat anyone who quotes you 1.0 as a hard line with suspicion. Treat anyone who has abandoned the comparison entirely with more.
When the PEG ratio stops working
It isn't universal, and knowing where it fails is most of using it well.
Negative or near-zero earnings. No meaningful P/E means no meaningful PEG. Early-stage companies need a different tool.
Volatile growth. A company whose earnings swing with a commodity cycle will produce a PEG that flatters it at the top of the cycle and condemns it at the bottom. Both readings are wrong.
Unreliable growth estimates. This is the big one, and it's quiet. PEG depends entirely on the expected growth rate, and that number is a forecast, usually an analyst consensus. Garbage in, confident-looking garbage out. Before trusting a PEG, look at what the estimate is built on and how often that company's estimates have been revised.
Very high growth rates. The arithmetic gets squishy at the extremes. A company projected to grow 80% a year produces a flattering PEG off a projection almost nobody sustains.
How this fits a GARP screen
Growth at a reasonable price is the approach the whole series is built on, and PEG is its central test. The target is a business growing consistently at 15% to 25% a year, with a moat real enough to defend that growth, at a price that doesn't already assume it.
A typical GARP screen looks for revenue growth above peers, operating margins above peers, return on invested capital consistently above the cost of capital, strong free cash flow, a P/E meaningfully below pure-growth comparables, and a PEG in the 1.0 to 1.5 range.
That's a narrower universe than pure growth or pure value screening produces, and it takes more work because you're optimizing on several dimensions at once. That's the tradeoff.
What to do with this
Take the three largest positions you own. Find each one's P/E and its consensus earnings growth estimate, both of which any brokerage screen will give you in under a minute. Divide. Write down the three numbers.
Then do the part that matters: for the one with the highest PEG, ask what growth rate would have to materialize to make today's price reasonable, and whether you actually believe it. That question is the entire exercise. The ratio is just how you get to it.
Valuation is the heart of Book One.
Book One works through the three financial statements, competitive position, management, industry, the full range of valuation methods, benchmarking against peers, and the quality and growth-versus-value questions underneath all of it. The Financial Ratios Guide is the desk reference, organized by category, with a case-study workbook built in.