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Everybody wants to know which stock to buy and which stock to sell. But how do you distinguish between the two?

For fundamental investors, it’s based on value.

**Which stocks are trading below their true value — and should be bought — and which stocks are trading above their true value and should be sold? **

The concept is simple, but the execution is difficult because of one thing:

How do we determine value?

For most, the P/E ratio is the answer. Despite its broad acceptance, the P/E leaves out one of the most important factors in investing: growth.

The PEG ratio *corrects* that error.

## What is the PEG Ratio?

**The price/earnings-to-growth ratio (PEG ratio), is a metric that investors use to value a stock by comparing its current market price to its earnings, and to its expected future growth.**

The PEG ratio was invented because a company that is *expected* to grow its earnings, all else being equal, is worth more than a company with little growth opportunity.

This fact is why growth companies have higher P/E ratios than value companies — investors are willing to pay *more* for higher potential growth.

### Advantages of PEG Ratio

Earnings growth (or lack thereof) and how much you pay for that growth is what matters when making investments into equities.

A low P/E ratio may make a stock look attractive, but understanding why its P/E is so low is what matters. More often than not, low P/E’s are the result of *low* growth prospects.

Adding a company’s expected future growth into the equation allows you to adjust companies with *higher* P/E ratios that also have *higher* growth rates, and compare them to companies with *lower* P/E ratios and *lower* growth rates.

### Disadvantages of PEG Ratio

There are two primary drawbacks for using the PEG ratio, both having to do with calculating the estimated growth:

- The EPS growth rate is based on forward-looking expectations and (like the weather) will not be 100% correct. It will also be less and less right the further into the future you look.
- The growth rate typically only considers a short time period, about 1-3 years. While this may give a fuller picture of a company’s value than the P/E, it may overstate the benefit of buying a stock with only a couple of years of high growth.

Each of these has the power to significantly skew a stock’s attractiveness. Take care when estimating future earnings (or trusting sources that attempt to do so).

### PEG Ratio Formula

The PEG ratio formula is as follows:

PEG = (Share Price / EPS) / EPS Growth Rate

The price-to-earnings ratio (P/E ratio) serves as the numerator in the equation, and is then divided by the expected earnings-per-share growth rate.

## PEG Ratio vs P/E Ratio: What’s the Difference?

The PEG ratio enhances the P/E ratio by factoring in expected earnings into the calculation.

**By factoring in expected earnings growth, the PEG ratio presents a more complete picture of whether a stock is over or undervalued.**

## PEG Ratio Example

To illustrate, consider the following table:

- To calculate the P/E ratio for Moderate Co, divide its current price of $146.12 by its 2018 EPS of $11.43 = 12.8x
- To calculate its EPS growth rate, take the estimated 2019 EPS of $13.25 and subtract the actual 2018 EPS of $11.43, then divide by $11.43 = 15.9%
- To calculate the PEG ratio, divide its P/E ratio of 12.8x by its expected growth of 15.9% = 0.80

Many investors would avoid Fast Co like the plague because of its high P/E ratio, asking themselves, “How can somebody pay 27x earnings!?”

But this misses the point.

Fast Co trades at a high P/E ratio *because *of its expected earnings growth.

When we divide all 3 companies by their expected growth rates, Fast Co now looks the cheapest, given its increasing EPS.

## (Projected or Actual) Earnings Growth

As mentioned earlier, there is considerable risk in using estimated earnings to drive the valuation process.

**As with any metric, the accuracy of the PEG ratio depends on the accuracy of the inputs.**

Actual earnings can vary widely from expectations. Because of this, while it is a helpful adjustment to the P/E, the PEG ratio can still only be one of the various factors when making investment decisions.

## The Bottom Line: PEG Ratio

The PEG ratio is a more meaningful measure of value than the P/E ratio alone. By taking potential growth into consideration, the PEG ratio allows you to evaluate a company's current share price in relation to its future earnings.

**However, the quality of the results from the formula depends on the quality of the inputs. **

Future growth must be estimated, there’s no way around that. And with estimates come errors.

Thus, the PEG ratio should be considered a useful tool for evaluating equities and should be seen as simply one more input to guide and inform investment decisions.