DEFINITION of PEG Payback Period
The PEG payback period is a key ratio that is used to determine the time it would take for an investor to double their money with a stock investment. The price-to-earnings growth payback period is the time it would take for a company's earnings to equal the stock price paid by the investor. A company's PEG ratio is used rather than their price-to-earnings ratio because it is assumed that a company's earnings will grow over time. In theory, the price/earnings to growth ratio helps investors and analyst determine the relative trade-off between the price of a stock, the stock's earnings per share (EPS), and the company's expected growth rate.
BREAKING DOWN PEG Payback Period
The best reason for calculating the PEG payback period is to determine the riskiness of an investment. As a measure of relative riskiness, the PEG payback period's primary benefit is as a measure of liquidity. Liquid investments and securities are generally considered less risky than illiquid variations; all else held constant. Generally the longer the payback period, the riskier an investment becomes. This is because the payback period relies on the assessment of a company's earnings potential. It is harder to predict such potential further into the future, and subsequently, there is a greater risk that those returns will not come to fruition.
Drawbacks of the PEG Ratio
A notable deficiency of the PEG ratio is that it's largely an approximation; a deficiency particularly subject to financial engineering or manipulation. None the less, the PEG ratio and resulting PEG payback period still enjoy widespread use in the financial press and within the analysis and reporting by capital markets strategists.
The growth rate used in the PEG ratio is generally derived in one of two ways. The first method uses a forward-looking growth rate for a company. This number would be an annualized growth rate (i.e., percentage earnings growth per year), usually covering a period of up to five years. The other method uses a trailing growth rate derived from a trailing financial period, such as the last fiscal year or the previous 12 months. A multi-year historical average may also be appropriate. The selection of a forward or trailing growth rate depends on which method is most realistic for future project results. For certain mature businesses, a trailing rate may prove a reliable proxy. For high growth or businesses experiencing an explosive new product, a forward-looking growth rate may be preferred.