PEG Payback Period: Meaning, Formula, Limitations

What Is the PEG Payback Period?

The PEG payback period, or price/earnings-to-growth (PEG) ratio, is a key ratio that is used to calculate the length of time it would take for an investor to double the amount invested in a stock. To determine the PEG ratio, divide the price-to-earnings ratio of the stock by the projected growth rate for the stock's earnings for a given time period.

Some investors consider the PEG ratio to be a more accurate reflection of a stock's value than the P/E ratio because it takes into account the stock's future rate of growth. The drawback of the PEG ratio is simply that it relies on a projected growth rate. Projected growth rates, no matter what the source, are best guesses.

Formula and Calculation of PEG Payback Period

The PEG ratio is calculated as follows: the stock's price-to-earnings ratio divided by the growth rate for the stock's earnings for a specified time period. The PEG payback period, therefore, is the length of time it would take to recoup the investment and then double it.

Generally, a PEG ratio of 1 indicates a fairly valued company. A PEG ratio greater than 1 suggests that a company is overvalued, while a ratio under 1 indicates it may be undervalued.

In theory, the price/earnings to growth ratio helps investors and analysts determine the relative trade-off between the price of a stock, the stock's earnings per share (EPS), and the company's expected growth rate.

What the PEG Payback Period Can Tell You

The best reason for calculating the PEG ratio, or the PEG payback period, is to determine the riskiness of an investment. As a measure of relative riskiness, the PEG payback period's primary benefit is as a measure of liquidity.

Liquid investments are generally considered less risky than illiquid ones, all else being equal. Generally the longer the payback period, the riskier an investment becomes.

In stocks, this is because the payback period relies on an assessment of a company's earnings potential. The longer the timeline, the harder it is to predict potential with any accuracy. In other words, the risk increases, and the projection could turn out to be wrong.

Limitations of Using the PEG Payback Period

A notable deficiency of the PEG ratio is that it's an approximation. This deficiency is particularly subject to financial engineering or manipulation. That is, much of the information that goes into the approximation comes from the executives of the company, who may take an overly optimistic view of its prospects.

None the less, the PEG ratio and resulting PEG payback period still enjoy widespread use in the financial press and within the analysis and reporting produced by capital markets strategists.

The growth rate used in the PEG ratio is generally derived in one of two ways. The first method uses a forward-looking growth rate for a company. This number would be an annualized growth rate such as the percentage earnings growth per year. This will usually cover a period of up to five years.

The other method uses a trailing growth rate derived from a past financial period, such as the last fiscal year or the previous 12 months. A multi-year historical average may also be appropriately used.

The selection of a forward or trailing growth rate depends on which method is most realistic for future project results. For certain mature businesses, a trailing rate may prove a reliable proxy. For high growth businesses, or young businesses just beginning a growth spurt, a forward-looking growth rate may be preferred.

In any case, it's important to remember that a projection is not a guarantee.