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adds one more. The PEG ratio is based on the P/E ratio with one more important factor thrown in: earnings growth. As explained in the last section, the P/E ratio has always been a good gauge to value stocks, but many have come to believe (and to some extent correctly) that it cannot be applied to stocks across the board. The P/E ratio is a very effective tool when gauging mature industries such as energy, transportation, and some industrials. But it falls short when it comes to other industries such as the high-tech. It may be fine to gauge a railroad stock using its P/E ratio — the company is financially healthy and delivers modest earnings growth of 5% year after year. But should you expect a high-tech stock delivering annual growth of 40% to have the same P/E ratio? Both companies may have the same EPS this year, but chances are the high-tech company’s earnings would far outstrip that of the railroad company within a couple of years. Given that fact, it would not make sense for both stocks to be valued the same way. There is something to be said for the future growth potential of the company when valuing its stock.

Enter the PEG ratio which is calculated by dividing the P/E ratio of a stock by the company’s percentage annual earnings growth. So how would one determine the growth rate of a company? Simply look at the company’s earnings growth for the past few years and its earning estimates for the coming year. Of course past performance and estimates are no guarantee of future results, but they are the best indicators we’ve got. A PEG ratio of one could indicate that the stock is fairly valued, less than one would mean an undervalued stock (good buy), and more than one could mean an overvalued stock (hold or sell).

Let’s look at an example. In year 2000 Cisco with a P/E ratio of 160 and annual EPS growth of 25% had a PEG ratio of 160 / 25 = 6.4. Now per our last statement this stock could have been considered overvalued and not worthy of investing in. Neither its P/E ratio nor its PEG ratio …