Transforming growth factor-beta is a multifunctional growth factor with roles in normal development and disease pathogenesis. One such role is in inhibition of lung branching morphogenesis, although the precise mechanism remains unknown. In an explant model, all three TGFβ isoforms inhibited FGF10-induced morphogenesis of mesenchyme-free embryonic lung endoderm. Inhibition of budding by TGFβ was partially abrogated in endodermal explants from Smad3^−/− or conditional endodermal-specific Smad4^Δ/Δ embryonic lungs. Endodermal explants from conditional TGFβ receptor II knockout lungs were entirely refractive to TGFβ-induced inhibition. Inhibition of morphogenesis was associated with dedifferentiation of endodermal cells as documented by a decrease in key transcriptional factor, NKX2.1 protein, and its downstream target, surfactant protein C (SpC). TGFβ reduced the proliferation of wild-type endodermal cells within the explants as assessed by BrdU labeling. Gene expression analysis showed increased levels of mRNA for Pten, a key regulator of cell proliferation. Conditional, endodermal-specific deletion of Pten overcame TGFβ's inhibitory effect on cell proliferation, but did not restore morphogenesis. Thus, the mechanisms by which TGFβ inhibits FGF10-induced lung endodermal morphogenesis may entail both inhibition of cell proliferation, through increased Pten, as well as inhibition or interference with morphogenetic mediators such as Nkx2.1. Both of the latter are dependent on signaling through TβRII.