Investors rely on valuation metrics to gauge whether a stock is fairly priced. Among these, the PEG ratio is popular for its ability to adjust a stock’s valuation based on future earnings expectations. Unlike the standard P/E ratio, which simply compares price to current earnings, PEG incorporates growth projections. It is simply a company’s P/E ratio divided by its growth rate. Theoretically, this makes it a more refined tool for assessing whether a stock is under- or overvalued.
But does the PEG ratio provide meaningful insights for broad market trends? To find out, we analyzed historical PEG data for the S&P 500 (1985 to 2020) and tested its effectiveness as a trading strategy. We used Yardeni Research’s PE ratio and its estimates of forward growth rates for the same period.
Exhibit 1. Mapping of the PEG ratio over time.
The conventional wisdom is simple:
- PEG → The stock is undervalued relative to its expected growth.
- PEG > 1.0 → The stock is overvalued relative to its growth.
Many investors consider 1.0 to be a key threshold. If a stock trades at a PEG below 1.0, it is seen as an opportunity. If it is above 1.0, caution is advised. If we use PEG to gage broad market trends, how often do these “undervalued” opportunities appear, and do they signal strong returns?
Using the S&P 500 data from 1985 to 2020 and forward growth estimates from Yardeni Research, here’s what we found:
- PEG :
- Throughout the 1980s, there were a handful of months when the PEG ratio dipped below 1.0.
- In the 2000s, this happened only three times.
- In the 2010s, it occurred just five times.
- The PEG ratio almost never provides consistent buying opportunities at this threshold.
- PEG as Market Timing Tool:
- We tested a strategy where an investor would buy the S&P 500 when the PEG ratio was below 1.0 and sell when it moved above 1.
- While this worked well in some periods—like the 1980s—it was far less effective in the 2000s and beyond.
- Expanding the threshold to 1.25 or 1.5 showed similarly mixed results.
- Volatility is High:
- The returns associated with different PEG levels varied significantly across decades.
- What worked in one period often failed in another, making it difficult to use the PEG ratio as a standalone market signal.
Table 1.
While the PEG ratio remains a useful tool for evaluating individual stocks, our analysis suggests that applying it as a market-wide signal is far less reliable. Historically, opportunities to buy when the PEG ratio falls below 1.0 have been rare, and the strategy of trading based on PEG thresholds has yielded inconsistent results, particularly since 2000.
While valuation metrics are valuable in investment decision-making, no single ratio should dictate market timing. Instead, investors should consider the PEG ratio as one piece of a broader analytical framework — complementing it with other fundamental and macroeconomic factors to make well-rounded investment decisions.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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