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

Mar 09, 2025

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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.

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):

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:

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:

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.

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.

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:

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.

Generally, a PEG below 1.0 suggests a stock may be undervalued, while anything above 2.0 might indicate overvaluation.

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.

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:

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:

A common investing mistake is judging companies from different sectors by the same P/E standards. A tech company with a P/E of 30 and 25% growth might be a better value than a consumer staples company with a P/E of 15 and 3% growth.

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

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.

Extreme values in either direction—very high or very low P/E or PEG ratios—almost always warrant a deeper investigation. There's likely a reason investors have priced them that way.

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.

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Fridson, Martin S., and Fernando Alvarez. "Financial Statement Analysis: A Practitioner's Guide," Pages 266-274. John Wiley & Sons, 2022.