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I wrote yesterday about the price to earnings ratio and how it is used to value companies and stocks. Today we will look at the PEG ratio and the advantages it has over the normal P/E ratio.

The PEG ratio is found by taking the P/E Ratio then dividing it by the annual EPS growth of the company. Most commonly the annual EPS growth of the company number is by either a five-year forward growth prediction or a five-year trailing growth number. By adding in the annual growth of a company we are able to differentiate between the high and low growth companies. There is certainly a reason that Google trades at a higher ratio than a company like Alcoa. This is where the PEG ratio has enormous amounts of benefits. As was written by investopedia a few years ago, the PEG ratio has truly taken the reigns from the P/E ratio in terms of valuation importance.

Let's look at an example of a well-known stock and figure its PEG ratio. EBAY currently trades at $33.35 on the NASDAQ. We then take a look at the company information on Yahoo Finance to see the EPS for this year and the expected growth rate for the next five years. Taking today's stock price of $33.35 and dividing this year's earnings estimate of $1.37 per share, we get a price to earnings ratio of 24.34 for EBAY. Yahoo Finance gives an expected 5 year growth rate of 18.74% for EBAY. Our formula should look like this 24.34/18.74, which equals 1.299. EBAY has a PEG ratio of 1.29.

Commonly it has been said that the average PEG ratio for a fairly valued stock should be 1.00, with anything above being overvalued and anything below being undervalued. Currently the S&P 500 as a whole has a PEG ratio of 1.51, which many market analysts view as the more "normal" fairly valued ratio now as compared to the 1.00 figure commonly given. Motley Fool wrote a very interesting article on the usefulness of the PEG ratio in predicting returns on stocks. Some of the major findings, 92% of companies with PEG ratios of less than 1 outperformed the market over a 3 year period. Only 47% of companies with ratios over 2 outperformed the market in the same 3 year period.

The PEG ratio is a terrific and quick way to value a company or a stock. The first thing I do when checking potential investments is gauge the PEG ratio. While the ratio should not be used as a sole reason for buying a stock, this ratio has more validity than the normal P/E ratio.