Using a PEG ratio to help find cheap stocks

What is a PEG Ratio? How can you use it in finding cheap stocks? Those are the two questions I will try to answer for you today.

First things first though, what exactly does PEG stand for? PEG stands for Price/Earnings to Growth. How is the PEG ratio calculated? To calculate a peg ratio you take the more commonly used price/earnings number and then divide it by the Annual Earnings Per Share growth of the company. By adding in the Annual EPS growth of a company we are able to take into account the earnings growth of a company when deciding whether it is cheap or not.

To understand why a PEG ratio is helpful let's take a look at an example of two stocks.

Coca Cola (NYSE:KO)- Price/earnings ratio= 19.31 PEG ratio=1.68

Google (Nasdaq:GOOG) Price/earnings ratio=36.44 PEG ratio=0.94

By using this set of data we see the stark differences of these two methods. Under the price/earnings method alone KO looks cheap and GOOG very expensive, but under the PEG ratio KO looks a little expensive and GOOG cheap.

I tend to put quite a lot of weight in the PEG ratio, especially when investing in a stock that I tend to hold for a long time. Having said that, there is one major drawback to the PEG ratio, it is totally dependent on the earnings estimates by analysts. If analysts are way off base, your PEG ratio won't be of much help. This is precisely why the PEG ratio should be used in conjuction with other valuation methods to decide which stocks are attractively valued.