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A stock's price/earnings to growth ratio may not be the first metric that jumps to mind when due diligence or stock analysis is discussed, but most would agree that the PEG ratio gives a more complete picture of stock valuation than simply viewing the price-earnings (P/E) ratio in isolation. (For related reading, see "Move Over, P/E, Make Way For The PEG.")

The PEG ratio is calculated easily, and represents the ratio of the P/E to the expected future earnings growth rate of the company.

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Common stocks represent a claim to future earnings. The rate at which a company will grow its earnings going forward is one of the largest factors in determining a stock's intrinsic value. That future growth rate represents everyday market prices in stock markets around the world.

The P/E ratio shows us how much shares are worth compared with past earnings. Most will use 12-month trailing earnings to calculate the bottom part of the P/E ratio. Inferences may be made by looking at the P/E ratio; for instance, high P/E ratios represent growth stocks, while low ones highlight value-oriented stocks. (For more insight, read "Understanding The P/E Ratio.")

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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.

PEG: 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.

PEG: 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.

Stock theory suggests that the stock market should assign a PEG ratio of 1 to every stock. 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. (To learn more, see "Introduction To Fundamental Analysis.")

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

--The market's expectation of growth is higher than consensus estimates; or

--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; or

--Analysts' consensus estimates are currently set too low.

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 1.4

Oil Stock XYZ:

Current P/E: 16 times earnings
Five-Year Projected Growth Rate:15%
PEG: 16/15, or 1.07

Also, if a company has little analyst coverage, good forward estimates may be hard to find. The enterprising investor may want to experiment with calculating PEG ratios across a range of earnings scenarios based on the available data and his or her own conclusions. (For more, see "Great Expectations: Forecasting Sales 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 2.4.

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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.

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

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 back burner.

This article is from Investopedia.com, the Web's largest site dedicated to financial education. Click here for more educational articles from Investopedia.

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