Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the implication of a lower PEG ratio?

1. Higher cost for growth

2. Paying less for each % growth

3. Lower growth potential

4. Higher valuation risk

The correct answer is: Paying less for each % growth

A lower PEG ratio indicates that an investor is paying less for each percentage of earnings growth expected from a company. The PEG ratio is calculated by taking the price-to-earnings (P/E) ratio and dividing it by the expected earnings growth rate. A value below 1 suggests that the stock is undervalued relative to its growth prospects, as investors are essentially getting more growth for a lower price. This measurement is important because it provides a more nuanced view of a company's valuation by taking into account both its current earnings and its future growth potential. Investors often seek stocks with a lower PEG ratio because it suggests an opportunity for higher returns, as they are essentially buying growth at a bargain price. Hence, for those looking to invest in companies poised for significant growth without overpaying, a lower PEG ratio reflects a favorable valuation.