PEG Ratio =                   P/E Ratio
                         Expected Annual EPS growth

We have already learned that when companies are expected to grow rapidly in the future, they generally exhibit high P/E multiples.  Investors are willing to pay more for a stock now if they expect to profit from increasing earnings in the future.  The anticipated earnings growth justifies the higher stock price relative to current earnings.

In order to compare apples to apples regarding companies with different growth models, the PEG Ratio was created.  This ratio attempts to even the score by dividing company P/E Ratios by their expected growth rates.

A problem with this ratio involves the fact that the growth rate is a prediction; it’s not a hard number.  The problem may be compounded when using “forward” earnings to construct the P/E Ratio.  In this case, two variables in the PEG equation are actually estimates.  A low PEG Ratio may result when the outlook for a company is too rosy, providing the misleading implication that the stock is underpriced.