The PEG ratio creates a normalized number that can be compared a

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The problem with the P/E ratio is its failure to account for growth in the equation. After all, an investor may be willing to pay 50x earnings for a company that is growing at 150% per year, but only 5x earnings for a company that is not growing at all. As a result, investors have begun to switch to using a modified ratio called the price-earnings to growth ratio (or PEG ratio). This ratio is calculated by dividing the P/E ratio by the company’s growth rate.

The PEG ratio creates a normalized number that can be compared across industries and even countries. The ratio assumes that slow-growth companies will always have lower P/E ratios, while high-growth companies will command higher multiples. However, every company will have a relatively normalized PEG ratio, despite their differences in growth rates. In essence, the PEG ratio was created to normalize the P/E ratio across companies of all growth rates.

Typically, PEG ratios at around 1.0 are considered to be fairly valued – that is, their P/E ratio is equal to their growth rate. Meanwhile, PEG ratios below 1.0 are considered undervalued and PEG ratios above 1.0 are considered overvalued. Of course, this rule has its exceptions and there are several important considerations when using the PEG ratio in order to avoid problems:

Check Future Growth – Often times, investors that use the PEG ratio base it on past growth rates, but it is important to look forward as well to see if expectations are in-line with historical results. If not, then a lower valuation may be justified.
Watch the Cash – High earnings per share growth can be manipulated, so it is important to check the cash flow statements to make sure that cash from operations is in line with net income, which signifies that they are really making the money they say.
Be Mindful of Liabilities – A dangerous balance sheet can be a good reason for a low valuation, so it is important to carefully look at the balance sheet and make sure the company has low debt and a good quick and current ratio (assets / liabilities).
Remember Liquidity – Just because a stock trades at a discount doesn’t mean that it is guaranteed to increase in price over time. One big reason for this is liquidity, or the number of shares traded per day. Smaller stocks, like those on the OTC-BB, may be less visible, and therefore trade at discounts for a long period of time.
In the end, the PEG ratio is a great way to quickly value a company without delving into discounted cash flow analysis or other time consuming methods. There are several things to watch out for when using this method, but keeping the above tips in mind should help investors effectively utilize this pinnacle of valuation!