Many investors rely on popular measures, such as price-to-book value and price-to-earnings ratios. One measure investors like to look at, especially during times of rising stock prices is the price-to-earnings to earnings-growth (PEG) ratio.

The price-to-earnings (PE) ratio divides a company’s share price by its earnings per share to give a rough indication of relative value. A relatively low PE doesn’t necessarily translate to an attractive investment opportunity. For this reason, some analysts prefer the price-to-earnings to earnings-growth (PEG) ratio. Believers in the PEG ratio think that the PE by itself is of limited value. Some companies are more expensive, or have higher valuations, than others. But that higher price tag may be worthwhile if the company is growing more rapidly. The PEG ratio is a way to quantify this mindset.

The PEG ratio takes a company’s PE ratio and divides it by earnings per share growth. For example, company XYZ has a share price of CHF 40 and earnings per share of CHF 4. This gives the company a PE ratio of 10. If the company’s earnings per share growth is 10%, the PEG would be 1. It’s assumed that a fairly valued company has a PEG of 1. Suppose now that the company’s earnings per share tumbles to CHF 2 and the stock price remains CHF 40. Now, the company’s PEG is 2 assuming earnings growth remains constant at 10%. This implies that the company is overvalued. In other words, investors are paying an unjustified premium given the current growth rate.

There are some drawbacks to using the PEG ratio. First of all, XYZ is not going to grow at a 10% growth rate forever. The PEG ratio doesnâ€™t suggest how long the 10% growth rate will persist or what the growth rate is likely to be 5 or 10 years from now. Also, when compared with more detailed discounted cash flow analyses, the PEG ratio tends to undervalue companies with extremely high, almost exponential growth rates.

While far from perfect, the PEG ratio still helps gauging relative value. Use it wisely!