The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected future growth. It is a ratio used to determine a stock's value while taking into account earnings growth.

PEG ratio = (Price / Earnings ratio) / Annual EPS growth

Let's look at two hypothetical stocks to see how the PEG ratio is calculated:

ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years.

20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66

XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years.

30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75

Using the examples above, the PEG ratio tells us that ABC Industries stock price is higher than its earnings growth. This means that if the company doesn't grow at a faster rate, the stock price will decrease. XYZ Micro's PEG ratio of 0.75 tells us that the company's stock is undervalued, which means it's trading in line with the growth rate and the stock price will increase.

It is generally accepted that a PEG ratio of 1 represents a reasonable trade-off between cost (as expressed by the P/E ratio) and growth. This would represent theoretical equilibrium between the market value of a stock and anticipated earnings growth. For example, a stock with an earnings multiple of 20 and 20% anticipated earnings growth would have a PEG ratio of 1.

PEG ratio results greater than 1 suggest one of the following:

The market's expectation of growth is higher than consensus estimates.

The stock is currently overvalued due to heightened demand for shares.

PEG ratio results of less than 1 suggest one of the following:

Markets are underestimating growth and the stock is undervalued.

Analysts' consensus estimates are currently set too low.

In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies overvalued relative to others. A lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive). A PEG ratio that gets close to 2 or higher is generally believed to be expensive, that is, the price paid appears to be too high relative to the estimated future growth in earnings.

PEG is a widely used indicator of a stock's potential value. It is favored by many over the price/earnings ratio because it also accounts for growth.Investors may prefer the PEG ratio because it explicitly puts a value on the expected growth in earnings of a company. The PEG ratio can offer a suggestion of whether a company's high P/E ratio reflects an excessively high stock price or is a reflection of promising growth prospects for the company.

A great feature of the PEG ratio is that by bringing future growth expectations into the mix, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This makes it easier to compare different industries, which tend to each have their own historical P/E ranges. For example, let's compare the relative valuation of a biotech stock to an integrated oil company:

Biotech Stock ABC

-Current P/E: 35 times earnings-Five-year projected growth rate: 25%

-PEG: 35/25, or 1.40 Oil Stock XYZ

-Current P/E: 16 times earnings

-Five-year projected growth rate: 15%

-PEG: 16/15, or 1.07

Even though these two fictional companies have very different valuations and growth rates, the PEG ratio allows us to make an apples-to-apples comparison of their relative valuations. What is meant by relative valuation? It is a mathematical way of asking whether a specific stock or a broad industry is more or less expensive than a broad market index, such as the S&P 500 or the Nasdaq.

So, if the S&P 500 has a current P/E ratio of 16 times trailing earnings and the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years, the PEG ratio of the S&P 500 would be (16/12), or 1.25.

1. The PEG ratio is less appropriate for measuring companies without high growth. Large, well-established companies, for instance, may offer dependable dividend income, but little opportunity for growth.

The PEG ratio is best suited to stocks with little or no dividend yield. Because the PEG ratio doesn't incorporate income received by the investor in its presentation of valuation, the metric may give unfairly inaccurate results for a stock that pays a high dividend.

Consider the scenario of an energy utility that has little potential for earnings growth. Analyst estimates may be 5% growth at best, but there is solid cash flow coming from years of consistent revenue. The company is now mainly in the business of returning cash to shareholders. The dividend yield is 5%. If the company has a P/E ratio of 12, the low growth forecasts would put the PEG ratio of the stock at 12/5, or 2.50. An investor taking just a cursory glance could easily conclude that this is an overvalued stock. The high yield and low P/E make for an attractive stock to a conservative investor focused on generating income. Be sure to incorporate dividend yields into your overall analysis. One trick is to modify the PEG ratio by adding the dividend yield to the estimated growth rate during calculations. To give us a meaningful interpretation of the company's valuation, take a look a look at the following example.

Example - Adding Dividend Yield to the Estimated Growth Rate

This energy utility has an estimated growth rate of about 5%, a 5% dividend yield and a P/E ratio of 12. In order to take the dividend yield into account, you could calculate the PEG like this:

P/E / (Growth Estimates + Yield) = (12 / (5 + 5)) = 1.2

2. A company's growth rate is an estimate. It is subject to the limitations of projecting future events. Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, and hype of investors.

The convention that (PEG=1) is appropriate is somewhat arbitrary and considered a rule of thumb metric. Mathematically, growth faster than growth of the economy cannot be infinite (or the company would eventually become larger than the economy), and the PEG ratio does not correct for the period of time that faster-than-normal growth will continue. In addition, there is no implicit or explicit correction for inflation (i.e. a company with growth equal to the rate of inflation is not growing in real terms). Hence, the PEG ratio lacks a coherent conceptual framework, and is used solely as a somewhat inquisitive metric of the extent of the growth/price trade-off.

At extremes, and particularly for low-growth companies, the PEG ratio implies valuations that may appear to be nonsensical. For example, the PEG ratio "rule of thumb" implies that a company with 1% growth in earnings per annum should have a P/E ratio between 1 and 2, a level that would appear to be extremely low. For companies with zero expected growth, the ratio is undefined (division by zero), and for companies with negative growth, the result (a negative PEG ratio, for example) may be meaningless.

Thorough and thoughtful stock research should involve a solid understanding of the business operations and financials of the underlying company. This includes knowing what factors the analysts are using to come up with their growth rate estimates, and what risks exist regarding future growth and the company's own forecasts for long-term shareholder returns.

Investors must always keep in mind that the market can, in the short-term, be anything but rational and efficient. While in the long run stocks may be constantly heading toward their natural PEGs of 1, short-term fears or greed in the markets may put fundamental concerns on the backburner.

When used consistently and uniformly, the PEG ratio is an essential tool that adds dimension to the P/E ratio, allows comparisons across diverse industries and is always on the lookout for value.