Chartered Financial Analyst (CFA) Practice Exam Level 2

In the context of Earnings Per Share (EPS) normalization, what does the PEG ratio represent?

1. Price to Book Value growth

2. Price to Earnings growth

3. Earnings to Price growth

4. Return on equity growth

The correct answer is: Price to Earnings growth

The PEG ratio, which stands for Price/Earnings to Growth ratio, is a valuation metric that helps investors understand the relationship between a company’s price-to-earnings (P/E) ratio and its expected future growth rate. It provides a more comprehensive view than the P/E ratio alone, as it takes into account the anticipated growth in earnings. By using the PEG ratio, investors can assess whether a stock is overvalued or undervalued based on expected growth rates. A PEG ratio of 1 is generally considered to indicate that the stock’s price is fairly valued relative to its earnings growth. A PEG ratio less than 1 may suggest that the stock is undervalued, while a ratio greater than 1 might indicate overvaluation. This focus on both price and growth together offers a better perspective for evaluating potential investments, particularly for high-growth companies, enabling investors to make more informed comparisons across different firms within the same industry or sector.