What it means
The price-to-earnings (P/E) ratio tells you how many dollars you pay for each dollar of annual earnings. A P/E of 10 means the share price is ten times this year's earnings.
That figure alone assumes earnings never change. The PEG ratio adjusts the P/E for growth by dividing it by the expected earnings growth rate.
The PEG payback period goes a step further. It asks how long it would take for growing earnings, added up year by year, to reach the share price.
The idea is intuitive. A company growing earnings quickly will reach the price sooner than a slow grower, even if both have the same P/E.
A stock with a high P/E but fast growth may therefore have a similar payback to a cheaper but slower company. The calculation is built year by year: start with one dollar of earnings, grow it each year at the expected rate, and see when the running total reaches the P/E.
The number of years needed is the payback period, and a spreadsheet is the usual way to find it. Analysts use it as a sense check on valuation.
A payback of five or six years may look reasonable for a stable growth company, whereas 15 or 20 years suggests that the market expects very high growth or that the share is expensive. A long payback also means the investor is relying heavily on forecasts that may not come true.
There are important limits. The calculation assumes the growth rate holds steady, which is rarely true over a long period, and it ignores dividends, debt and the time value of money (the idea that money today is worth more than money later).
It should be treated as a rough guide alongside other valuation measures.
In practice
Real-world examples.
Example
An investor compares two retailers, both with a P/E of 15. Retailer A is growing earnings at 25% a year and Retailer B at 5%, so A has a much shorter payback period and may deserve a higher valuation.
Example
A fund analyst finds that a software company with a P/E of 40 and expected growth of 30% has a payback of about 10 years. She decides that the stock is acceptable only if the growth forecast is realistic.
Example
A founder preparing to sell his business shows a buyer that, with a price of $5,000,000 and first-year profit of $500,000 growing 15% a year, the buyer's investment pays back in earnings in about 7 years.
Formula
Calculation
Find the smallest number of years n so that: Earnings in year 1 x [(1 + g)^n - 1] / g is at least the share price, where g is the growth rate.
Suppose a share costs $20 and next year's earnings are expected to be $2.00 per share, giving a P/E of 10. Earnings grow at 20% a year. Year 1: $2.00 (running total $2.00). Year 2: $2.40 (total $4.40). Year 3: $2.88 (total $7.28). Year 4: $3.456 (total $10.736). Year 5: $4.147 (total $14.883). Year 6: $4.977 (total $19.860). After six years cumulative earnings of about $19.86 are just short of the $20 price, and the total passes $20 early in year 7, so the PEG payback period is about 6 years.Case study
Seen in the real world.
Thornfield Analytics is an illustrative, fictional research firm that screens stocks for a client fund. Its junior analyst flagged a manufacturer with a P/E of 12 as cheap, but the senior analyst built a payback table using the company's real growth outlook of only 2% a year.
At that growth rate, cumulative earnings took about 11 years to reach the price. A second stock, with a P/E of 18 but growth of 18% a year, reached its price in roughly 9 years.
The fund preferred the second stock, and revisited the forecast each quarter. The illustrative lesson is that a low P/E can hide a long payback, and growth rates deserve as much scrutiny as the price.
Watch out
Common mistakes.
- Confusing the PEG payback period with the PEG ratio, when one is a number of years and the other is a ratio.
- Assuming the growth rate will last forever, when high growth tends to fade over time.
- Ignoring dividends, debt and risk, which can change what the investment is really worth.
Questions
People also ask.
How is it different from a normal payback period?
A normal payback period looks at cash returned from a project, while this one looks at a share's earnings growing over time.
What is a good PEG payback period?
There is no fixed rule, but shorter is better, and many investors become cautious when it passes ten years.
Can it be negative or undefined?
If earnings are falling or negative, the running total may never reach the price, so the measure is not meaningful.
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