Using the Price-to-Earnings (P/E) Ratio and PEG Ratio to Assess a Stock

The price-to-earnings (P/E) ratio ranks among Wall Street’s most quoted statistics, revealing how much investors pay for each dollar of a company’s profits. But this popular metric only tells half the story. Suppose you spot a stock trading at just 10 times earnings while its industry peers trade at 20 or more—sounds like a bargain, right? Not necessarily. Savvy investors never rely on a single metric when evaluating stocks.

Enter the price-to-earnings-to-growth (PEG) ratio, which builds on the P/E foundation by factoring in the potential for future growth in earnings. Since understanding how to interpret these numbers can significantly improve your ability to identify truly promising stock prospects, we take you through both below.

Understanding the Price-to-Earnings (P/E) Ratio

The P/E ratio is a financial shorthand for how much investors are willing to pay for each dollar a company earns—the “price tag” on a company’s profits. This tool helps you determine whether a stock’s current price is reasonable relative to its earning power.

To calculate the P/E ratio, you divide the stock’s current price by its earnings per share (EPS):

P/E Ratio = Stock Price ÷ EPS.

For example, if a company’s stock trades at $75 and its EPS is $3, investors are paying $25 for every $1 of earnings, resulting in the following:

P/E Ratio: 25 = $75 ÷ $3.

Investors use two different versions of the P/E ratio. The trailing P/E uses actual earnings from the past 12 months. The forward P/E uses analysts’ earnings forecasts for the coming year—it’s thus more speculative. For instance, a company with a trailing P/E of 30 might have a forward P/E of just 18 if analysts expect earnings to grow 40% in the coming year.

The P/E ratio speaks volumes about investor expectations. A high P/E suggests investors anticipate strong future growth and are willing to pay a premium today. A low P/E could indicate investors are skeptical about growth prospects or that the stock is potentially undervalued.

This ratio is most valuable when comparing companies within the same industry. The key is understanding what’s typical for a particular business sector before drawing conclusions. The table below provides that info as of January 2025 for all the major U.S. economic sectors:

Limitations of the P/E Ratio

The P/E ratio, while widely used, comes with significant blind spots that can lead investors astray if used in isolation. Understanding these limitations is critical for making informed investment decisions.

• The P/E ratio ignores growth prospects. A company with a seemingly high P/E of 30 might be undervalued if its earnings are growing by 40% annually. Conversely, a temptingly low P/E could simply reflect a company in decline. This one-dimensional view fails to account for a business’s trajectory.
• The P/E ratio also overlooks debt levels. Suppose a company has an attractive P/E of 2.0. This ratio won’t tell you whether the company is drowning in debt and at risk of bankruptcy. Since the P/E calculation focuses solely on earnings relative to price, it reveals nothing about the strength or weakness of a company’s balance sheet.
• It’s vulnerable to accounting manipulation. Companies can artificially improve their P/E ratios by selling assets or improperly booking revenues. Because P/E is based on accounting earnings rather than cash flow, it can mask serious cash flow problems that might threaten a company’s financial health.
• Industry-agnostic comparisons using P/E ratios can be particularly deceptive. Comparing P/E ratios across different sectors is like comparing apples to oranges – the numbers exist in different contexts.
• The P/E ratio assumes earnings patterns will continue. Macroeconomic factors like inflation can dramatically impact future growth. With the five-year breakeven inflation rate at 2.66% as of February 2025, investors should adjust growth projections accordingly, especially in inflation-sensitive sectors.

For these reasons, investors should always use P/E alongside other metrics like PEG ratio, debt-to-equity, and free cash flow to provide a complete picture.

Understanding the Price/Earnings-to-Growth (PEG) Ratio

While the P/E ratio leaves investors blind to growth potential, the PEG ratio shines a spotlight directly on it. This more comprehensive tool incorporates future earnings projections into the valuation equation, clarifying whether a stock’s price is justified by its growth prospects.

The PEG ratio is calculated by dividing the P/E ratio by the projected annual EPS growth rate:

PEG Ratio = P/E Ratio ÷ Annual EPS Growth Rate.

This provides the context for a valuation. For example, a company with a P/E of 30 and projected annual earnings growth of 20% would have a PEG ratio of 1.5.

The PEG ratio’s real strength lies in its ability to normalize comparisons across different industries. Suppose you’re assessing two companies: a tech app firm trading at a P/E of 45 with 50% projected growth (PEG of 0.9) and a utility with a P/E of 15 and 3% growth (PEG of 5.0). Despite its much higher P/E, the tech app company might represent a better value once its potential for growth is factored in.

However, the PEG ratio has limitations. It relies heavily on growth forecasts, which are inherently uncertain and can be overly optimistic. Analyst projections can sometimes miss the mark dramatically, making the PEG ratio only as reliable as the growth estimates it incorporates.

The PEG ratio’s usefulness also varies widely by sector. It provides valuable insights for high-growth industries like technology or biotechnology but offers less guidance for mature sectors like utilities or consumer staples, where earnings growth tends to be modest but stable.

Comparing P/E and PEG Ratios

The P/E and PEG ratios work best as complementary tools in an investor’s analytical tool kit. The P/E ratio tells you how much you’re paying for a company’s current earnings, while the PEG ratio reveals whether that price is reasonable given the company’s expected growth trajectory.

To illustrate how these metrics work together, consider two hypothetical scenarios:

• NVIDIA Corporation (NVDA) has a P/E of 35 and projected annual earnings growth of 25%, resulting in a PEG ratio of 1.4.
• Coca-Cola Co. (KO) has a lower P/E of 22 but slower projected growth of 4%, giving it a PEG ratio of 5.5.

Coca-Cola’s lower P/E might seem more attractive. However, NVIDIA’s much lower PEG ratio suggests it offers better value once growth is factored in. This explains why growth-oriented investors often focus more on PEG ratios, while income-focused investors in stable sectors like utilities might prioritize P/E ratios and dividend yields.

Investors tend to use these metrics in a sequence:

1. They begin by using P/E ratios to identify sectors or companies that appear reasonably priced compared with peers or historical averages.
2. Then they apply the PEG ratio to filter for companies with strong growth potential relative to their present valuation.

Practical Application of P/E and PEG Ratios

To apply these ratios most effectively in your investment strategy, here are suggested steps:

1. Identify potential mispricings by comparing ratios among companies in the same industry. A significant deviation from peer averages often signals either an opportunity or a warning sign.
2. Use PEG ratios to standardize comparisons across different sectors. This helps you identify which companies offer the best value relative to their growth prospects, regardless of industry.
3. Consider a company’s stage in its life cycle. Startups and early-growth companies may have high P/E ratios but attractive PEG ratios because of their rapid expansion phase.
4. Consider the broader economic conditions. During periods with low interest rates, investors generally accept higher P/E ratios across all sectors, while rising rates typically compress these multiples.

Remember that these ratios are starting points, not final verdicts. Always supplement them with analysis of debt levels, free cash flow, competitive positioning, and management quality to build a comprehensive investment case.

The Bottom Line

The P/E ratio offers a snapshot of what investors are paying for a company’s current earnings, while the PEG ratio improves this picture by factoring in expected earnings growth. Together, they provide a more comprehensive way to value stocks rather than using them on their own.