CFA Level IEquity InvestmentsHard
An analyst compares two stocks using the PEG ratio (P/E divided by expected earnings growth rate, expressed as a whole number). Stock X trades at a P/E of 18 with expected annual EPS growth of 12%. Stock Y trades at a P/E of 10 with expected annual EPS growth of 8%. Based solely on PEG ratios, which stock appears more attractively valued relative to its growth prospects?
- AStock X, because its PEG ratio of 1.50 is higher than Stock Y's
- BStock X, because its P/E ratio is higher, indicating stronger growth
- CStock Y, because its PEG ratio of 1.25 is lower than Stock X's
- DStock Y, because its P/E ratio of 10 is the lowest in absolute terms
Show answer & explanationAnswer & explanation
Correct answer: C. Stock Y, because its PEG ratio of 1.25 is lower than Stock X's
PEG ratio = P/E ÷ expected growth rate (as a whole number). Stock X: 18/12 = 1.50. Stock Y: 10/8 = 1.25. A lower PEG ratio suggests a stock is more attractively priced relative to its expected growth, so Stock Y appears more attractive despite its lower absolute P/E and growth rate.
Why the other options are wrong
- A. Incorrect; a higher PEG ratio indicates a stock is more expensive relative to growth, not more attractive.
- B. Incorrect; a higher P/E alone does not indicate stronger growth without adjusting for the growth rate via PEG.
- D. Incorrect; comparing absolute P/E ratios ignores growth differences, which is precisely what PEG is designed to correct for.
PEG Ratio
The PEG ratio (Price/Earnings-to-Growth) adjusts the P/E ratio for expected earnings growth, calculated as P/E divided by the expected growth rate (expressed as a whole number); a lower PEG generally suggests a stock is more attractively valued relative to its growth.
- Formula: PEG = P/E ÷ expected EPS growth rate (%, as whole number)
- Lower PEG suggests better value relative to growth (rule of thumb, PEG < 1 is often seen as attractive)
- Ignores risk differences, so should be used alongside other measures
Memory trick: Cheap growth wins: lower PEG, better deal.