The PEG ratio

A gardener offers Arjun two mango saplings for the same price: ₹500 each. They look alike. But he tells Arjun a secret: the first one grows very slowly and will give only a few mangoes for years. The second one is a fast-growing kind that will be a big fruiting tree in half the time.

Same price, very different value. Paying ₹500 for the slow tree is not the same deal as paying ₹500 for the fast one. The fast tree is clearly the better bargain, even though the price tag is identical - because you are really paying for the fruit to come, not just the sapling in your hand.

Peter Lynch used this exact thinking on shares. Two shares can have the same price-tag-for-profit, yet one is a much better deal because it is growing faster. He is famous for a simple tool that compares price to growth. To understand it, we first need two small money words: P/E and PEG. Do not worry - they are easier than they look.

First, profit: the money a company keeps after paying all its costs. Now, P/E. P/E means Price compared to profit ("P" is price of one share, "E" is the earnings, another word for profit, per share). If a share costs ₹100 and the company earns ₹5 of profit per share in a year, its P/E is 100 ÷ 5 = 20. You can read it as: "I am paying 20 rupees for every 1 rupee of yearly profit." A low P/E looks cheap; a high P/E looks expensive.

But Lynch said P/E alone is not enough, because it ignores growth - how fast the profit is getting bigger each year. A company growing fast deserves a higher price, just like the fast mango tree deserves the same ₹500 more than the slow one does.

So he used PEG: the P/E divided by the growth. If two companies have the same P/E of 20, but one grows its profit 10% a year and the other grows 40% a year, they are not equally priced in real value. The faster one is the better deal.

The maths is easy. PEG = P/E ÷ growth rate. For Slow Foods: 20 ÷ 10 = 2.0. For Quick Foods: 20 ÷ 40 = 0.5. Lynch's rough guide was that a PEG around 1 is fair, below 1 may be a bargain, and well above 1 may be expensive. Quick Foods, at 0.5, is the better deal for its growth, even though its price-tag-for-profit is identical to Slow Foods'. That is the whole read: do not judge a price alone - judge it next to how fast the profit is growing.

illustrative Kabir sees two shares. Bright Toys has a P/E of 15, which looks cheap. Shiny Toys has a P/E of 30, which looks expensive. If he judged by price alone, he would grab Bright Toys and avoid Shiny Toys.

Now add growth. Bright Toys is growing its profit only 5% a year - its PEG is 15 ÷ 5 = 3.0, actually quite expensive for such slow growth. Shiny Toys is growing 30% a year - its PEG is 30 ÷ 30 = 1.0, fair. So the share that looked cheap (Bright Toys) is really the pricey one, and the share that looked dear (Shiny Toys) is fairly priced for how fast it is growing. Judging by the price tag alone flipped the answer upside down. This is why Lynch always put price and growth side by side: a low P/E can hide a bad deal, and a high P/E can hide a fair one.

The "growth" number is a guess about the future. PEG depends on how fast profit will grow, and nobody truly knows that. If a company grew 40% last year, it may grow only 10% next year. Feed in a hopeful growth number and PEG will happily tell you a share is "cheap" when it is not. The tool is only as honest as the growth guess you put in.

A tiny PEG can be a warning, not a gift. Sometimes a share has a very low PEG because wise people doubt the growth will last, or fear the profit is not real. A "bargain" that is too good often means the market knows something you do not. A low PEG is a reason to investigate, not to celebrate.

PEG does not work for every kind of company. For cyclicals (up-and-down businesses) and for companies with no steady growth, the growth number jumps around wildly, and PEG becomes meaningless. It suits fairly steady growers best. Using it on the wrong kind of company gives a confident-looking but useless answer.

PEG travels fine to India, but treat the growth number with extra suspicion here. Fast-growing Indian companies are often priced very high because everyone is excited about their growth - and if that growth slows even a little, the "fair" PEG can turn ugly fast. Also, reported profit can sometimes be flattered by one-time events or loans, which makes both P/E and PEG misleading. So use PEG the way Lynch meant it - as a quick sanity check that stops you from calling a slow company "cheap" just because its price tag looks small - but never as a magic number. Always ask where the growth comes from and whether it can really last, because a made-up growth number produces a made-up bargain.

• Never judge a share's price without its growth beside it. A low P/E is not automatically cheap; a high P/E is not automatically dear.
• Do the simple sum: PEG = P/E ÷ growth rate. Around 1 is fair, below 1 may be a bargain, well above 1 may be pricey.
• Question the growth number. Ask where it comes from and whether it can last, since PEG is only as good as that guess.
• Treat a very low PEG as a question, not a prize. Ask why the market is so unsure about the growth.
• Don't use PEG on up-and-down (cyclical) companies. Their jumpy growth makes the number meaningless.
• Check that the profit is real, not flattered by loans or a one-time event, before you trust any P/E or PEG.