Simple Summary:
Think of a company's stock price like the price tag on a car.
1. PE Ratio = Price tag ÷ yearly earnings
Faster growth = higher price tag (like a newer model)
More risky = lower price tag (like a car with problems)
Needs lots of repairs/reinvestment = lower price tag (takes money to maintain)
2. PEG Ratio = (PE Ratio) ÷ growth rate
Tries to be "fair" by considering growth, but has problems:
Doesn't account for risk (a dangerous but fast-growing company looks cheap)
Doesn't account for efficiency (a company that spends wastefully looks cheap)
Doesn't work well for very slow or very fast growers
3. Relative PE = Your car's price ÷ average car price
Helps see if your car is expensive compared to the market
Most cars are cheaper than average (because a few super-expensive cars pull the average up)
Best used to compare over time (is your car more expensive than it usually is?)
Big Picture:
You can't just look at the price tag alone. You need to ask:
Two companies with the same PE might be completely different—one might be a safe, efficient grower while the other is a risky, wasteful grower. The numbers tell the story only when you understand what's behind them.
Not all growth is created equal.
Good Growth (Valuable) = Higher PE
This is efficient, profitable, and sustainable growth. The company grows its earnings by:
Reinvesting a smaller amount of money
Into projects with high returns (like 20-30% returns)
While taking on reasonable risk
Example: A software company that grows 15% per year simply because its existing customers love the product and pay more (high margins, low extra cost). This deserves a high price tag (high PE).
Bad Growth (Destructive) = Lower PE
This is inefficient, unprofitable, or risky growth. The company grows by:
Reinvesting a massive amount of money (eating up cash flow)
Into projects with low or mediocre returns (like 5-8% returns, maybe below its own cost of capital)
While taking on high risk
Example: A construction company that only grows by taking on huge, low-margin projects with lots of debt. It's growing revenue, but destroying shareholder value. This deserves a lower price tag (low PE).
Why the PEG Ratio Fools People:
A company with Bad Growth might look cheap on a PEG ratio because it has a low PE (bad) divided by a high growth rate (seemingly good).
PEG = (Low PE due to bad growth) / (High Growth Rate from risky projects)
The math gives you a small, "attractive" PEG number, tricking you into thinking it's a bargain. In reality, the market has given it a low PE for a good reason—its growth is dangerous or wasteful.
That's why Damodaran says: "Other things are difficult to hold equal." The moment you see high growth, you must immediately ask: "At what cost and at what risk?"
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More detailed discussion:
These are key principles from Aswath Damodaran’s work.
Summary & Core Idea
Damodaran systematically links valuation multiples (PE, PEG, Relative PE) to the three fundamental drivers of value: Growth, Risk, and Reinvestment (which drives cash flows). The central theme is that multiples are not arbitrary but are determined by these underlying financial realities.
Elaboration & Commentary
1. PE Ratio and Fundamentals
Damodaran’s three propositions decompose the standard discounted cash flow model into its PE implications:
Growth ↑ → PE ↑: Because future earnings are more valuable.
Risk ↑ → PE ↓: Higher discount rate reduces present value.
Reinvestment Needs ↑ → PE ↓: More capital must be plowed back to sustain growth, reducing free cash flow to equity.
Key Insight: In practice, these variables are correlated. High-growth firms often face higher risk and require high reinvestment, creating a natural tension. A firm with high growth but very high risk and reinvestment may still have a low PE. This explains why a simplistic “high PE = overvalued” approach fails.
2. PEG Ratios and Fundamentals
The PEG ratio (PE / Growth Rate) attempts to standardize for growth, but Damodaran shows its severe limitations:
Proposition 1: Risk is ignored in PEG. A risky firm with high growth may have a deceptively low PEG, luring investors who don’t adjust for risk (Corollary 1).
Proposition 2: Reinvestment efficiency (ROIC vs. Cost of Capital) matters. Two firms with 20% growth aren’t equal if one achieves it by investing 50% of earnings at a 40% return, and the other invests 80% at a 25% return. The more efficient firm deserves a higher PEG (Corollary 2 warns of “cheap” PEG traps).
Proposition 3: PEG is non-linear and skewed. Very low-growth firms (<5%) often have high PEs due to stable cash flows or dividend yields, inflating PEG. Very high-growth firms (>30%) often have high PE due to anticipation of sustained advantage. Thus, comparing a 2% growth firm (PEG=15) to a 25% growth firm (PEG=1) is misleading.
Bottom line: PEG does not neutralize growth and can be dangerously misleading across different risk, return, and growth ranges.
3. Relative PE
Relative PE (Firm PE / Market PE) is a normalization metric to compare across time or against historical norms.
It controls for market-level interest rates, risk premiums, and macroeconomic conditions affecting all PEs.
Comparison over time is its strength: If a firm historically traded at 0.8× market PE but now trades at 1.2×, it signals overvaluation relative to its own history, assuming fundamentals haven’t changed.
Skewness note: Damodaran highlights that the average relative PE is 1.0 (by definition), but the median is less than 1 because the PE distribution has a long right tail (some very high PE firms pull the average up). This means more than half of firms trade below the market PE—a crucial statistical insight often missed.
Critical Implications & Practical Use
Multiples are proxies for DCF: Every multiple embeds assumptions about growth, risk, and reinvestment. Use them only after understanding what those assumptions are.
PEG is flawed but popular: Its simplicity drives its use, but it’s unreliable for cross-sectional comparisons unless firms have similar risk, reinvestment needs, and growth rates. Better to use a PEG adjusted for risk and ROIC.
Relative PE for historical context: More useful than absolute PE when judging whether a stock is expensive relative to its own historical range or the market cycle.
The “other things held equal” caveat: This is the entire challenge in practice. When comparing multiples, you must ask: Are growth, risk, and reinvestment profiles similar? If not, difference in multiples may be justified.
Screening pitfalls: Screening for low PE or low PEG often selects firms with high risk, poor growth prospects, or low efficiency—precisely the “value traps.”
