What it means
GARP starts from a simple objection to both of the styles it sits between. Deep value investing often buys businesses that are cheap for good reason, while pure growth investing often pays so much for expansion that even excellent results disappoint the market.
The approach therefore screens on two things at once: evidence of genuine growth in earnings, and a valuation that does not already assume the growth will continue forever. A company growing earnings 20% a year on a price-to-earnings ratio of 24 is a GARP candidate; the same growth on a ratio of 90 is not.
The PEG ratio is the standard shorthand. It divides the price-to-earnings ratio by the expected annual earnings growth rate expressed as a whole number, and a result at or below 1.0 is traditionally treated as attractive, with anything above 2.0 looking expensive relative to growth.
Serious practitioners do not stop at the PEG figure. They also look for consistent rather than spiky earnings growth, sensible debt levels, returns on equity above the cost of capital, and cash flow that actually supports the reported profits.
The main weakness is that the whole approach depends on a growth forecast, and forecasts are frequently wrong. A low PEG ratio built on an optimistic analyst estimate is not a bargain; it is an error waiting to be discovered.
In practice
Real-world examples.
Example
A fund manager screens 500 listed companies for a PEG below 1.3, five years of positive earnings growth and net debt below twice earnings before interest, tax, depreciation and amortisation. The screen returns 22 names, which the team then researches individually rather than buying mechanically.
Example
A private investor compares two industrial suppliers. One trades on 12 times earnings with 4% growth, giving a PEG of 3.0, while the other trades on 18 times with 18% growth, giving a PEG of 1.0, and she buys the apparently more expensive company.
Example
A board reviewing its own share price notices that the company trades on a PEG of 0.7 because the market doubts the growth guidance. Rather than declaring the shares undervalued, the directors treat it as a signal that the guidance itself is not believed and revise their investor communications.
Formula
Calculation
PEG ratio = price-to-earnings ratio / expected annual earnings growth rate (as a whole number)
Consider three companies.
Company A trades at $60 a share with earnings per share of $2.50 and expected growth of 20%.
Price-to-earnings ratio = $60 / $2.50 = 24
PEG = 24 / 20 = 1.2
Company B trades at $40 a share with earnings per share of $2.00 and expected growth of 8%.
Price-to-earnings ratio = $40 / $2.00 = 20
PEG = 20 / 8 = 2.5
Company C trades at $120 a share with earnings per share of $1.20 and expected growth of 40%.
Price-to-earnings ratio = $120 / $1.20 = 100
PEG = 100 / 40 = 2.5
Company B looks cheapest on the price-to-earnings ratio alone and Company C looks the fastest growing, yet both carry a PEG of 2.5. Company A, with the middling multiple and solid growth, is the GARP choice at a PEG of 1.2.Case study
Seen in the real world.
What follows is an illustrative and fictional case. The Larkspur Equity Fund built its whole process around a PEG discipline, buying only companies with a PEG below 1.5 and rejecting anything above 2.0 regardless of how attractive the story sounded. In one review it held Company A on a PEG of 1.2 and passed on two alternatives that both screened at 2.5.
The decision looked wrong for eighteen months. The fast-growing Company C, priced at 100 times earnings, rose sharply while Larkspur's holding drifted, and two clients questioned whether the discipline was costing them money.
When growth expectations for the fast-growing name were cut from 40% to 22%, its share price halved within a quarter, while Larkspur's holding continued compounding earnings at close to the expected 20%. The illustrative point of this fictional example is not that PEG screening always wins, but that a valuation discipline is only useful if it survives the period when it appears to be failing.
Watch out
Common mistakes.
- Treating any PEG below 1.0 as automatically cheap, without checking whether the growth forecast behind it is credible.
- Using a single year of forecast growth instead of a sustainable multi-year rate, which makes cyclical companies look far cheaper than they are at the top of their cycle.
- Applying the PEG ratio to loss-making companies or businesses with barely positive earnings, where the price-to-earnings ratio is meaningless in the first place.
Questions
People also ask.
What counts as a reasonable PEG ratio?
A PEG at or below 1.0 is traditionally considered attractive and anything above 2.0 expensive, though the sensible range varies with interest rates and sector.
How is GARP different from value investing?
Value investing looks primarily for a low price relative to assets or current earnings, while GARP insists on real growth as well and will pay a higher multiple to get it.
Does the PEG ratio work for every sector?
No, it suits companies with steady positive earnings and struggles with banks, cyclical resource businesses and early-stage firms whose earnings are volatile or negative.
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