Chartered Financial Analyst (CFA) Practice Exam Level 2

What is a desirable characteristic of the PEG ratio in stock evaluation?

1. Higher ratios are preferred for growth

2. Lower ratios indicate better value

3. Ratios should equate to the industry average

4. Consistent ratios over time are preferred

The correct answer is: Lower ratios indicate better value

The PEG ratio, which stands for Price/Earnings to Growth ratio, is particularly valuable in evaluating stocks with growth potential. A desirable characteristic of the PEG ratio is that lower ratios indicate better value. When the PEG ratio is less than 1, it suggests that a stock might be undervalued relative to its earnings growth expectations. This is appealing to investors because it indicates that the stock's price does not fully reflect its growth prospects, thereby offering a potential investment opportunity. In contrast, if the PEG ratio is high, it may indicate that buyers are overpaying for growth, which might not be sustainable. Therefore, investors often look for lower PEG ratios, as these signify a more attractive investment compared to peers with higher ratios. This approach allows investors to identify stocks that provide a balance between price and growth potential, maximizing their investment's effective value.