Prospective Earnings Growth (PEG Ratio)


The idea is to scale the P/E ratio by earnings growth. Higher P/E multiples could be a result of higher growth opportunities. Expected earnings growth is usually derived from proprietary sources such as Institutional Brokers' Estimate System (IBES), First Call, or Zach's. The usual implementation is to divide the current P/E ratio by the five-year prospective earnings growth. This ratio is problematic if expected earnings growth is negative. As with the usual P/E ratio, zero or very small earnings causes problems too. For stock selection, I usually recommend looking at E/P (earnings price ratio) and expected earnings growth as two separate factors rather than a single PEG ratio. I also recommend looking at different horizons for expected earnings growth -- not just five years.

Investing Essentials

Copyright © 2011 Campbell R. Harvey, Professor of Finance, Fuqua School of Business at Duke University

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