Investors rely on valuation metrics to measure whether a stock is quite pricey. Of these, the PEG ratio is popular for its ability to adjust the valuation of stocks based on future earnings expectations. Unlike the standard P/E ratio, which simply compares prices with current revenue, PEG incorporates growth forecasts. This is simply the company's P/E ratio divided by growth rate. In theory, this makes it a more refined tool for assessing whether inventory is undervalued or overvalued.
But does PEG ratio offer meaningful insight into a wide range of market trends? To investigate, historical PEG data from the S&P 500 (1985-2020) were analyzed and its effectiveness was tested as a trading strategy. We used estimates of forward growth rates over the same period as Yardeni Research's PE ratio.
Figure 1. Mapping of PEG ratios over time.
Traditional wisdom is simple:
- PEG <1.0 → Inventory is undervalued compared to expected growth.
- PEG> 1.0 →Inventory is overvalued compared to its growth.
Many investors consider it 1.0 It becomes an important threshold. If the shares are traded on pegs below 1.0, it is considered an opportunity. If it exceeds 1.0, we recommend that you take caution. When using PEG to gauge a wide range of market trends, how often do these “undervalued” opportunities appear and signal strong returns?
Using S&P 500 data from 1985 to 2020, and forward growth estimates from Yardeni Research, here is what we found.
- PEG <1.0 is rare:
- Throughout the 1980s, there were months when the PEG ratio fell below 1.0.
- In the 2000s, this happened only three times.
- It happened only five times in the 2010s.
- PEG ratios offer little consistent purchase opportunities at this threshold.
- Pegs as a market timing tool:
- We tested the strategy of selling the S&P 500 when the PEG ratio is below 1.0.
- Like the 1980s, this worked well in some eras, but was far less effective after the 2000s.
- Extending the threshold to 1.25 or 1.5 showed similar mixed results.
- The volatility is high:
- The returns associated with different PEG levels have been significantly different over decades.
- What worked in one period often failed in another period, making it difficult to use PEG ratios as a standalone market signal.
Table 1.
While PEG ratios remain a useful tool for assessing individual stocks, the analysis suggests that applying them as a market-wide signal is less reliable. Historically, the opportunity to buy when the PEG ratio falls below 1.0 has been rare, and trading strategies based on PEG thresholds have resulted in inconsistent results, particularly since 2000.
While valuation metrics are valuable in investment decision-making, a single ratio should not determine market timing. Instead, investors should view PEG ratios as one part of a broader analytical framework. Complement other basic and macroeconomic factors to make balanced investment decisions.
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All posts are the opinions of the author. Therefore, they should not be interpreted as investment advice, and the opinions expressed necessarily do not reflect the views of the CFA Institute or the author's employer.
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