This term was popularized by Peter Lynch, a very successful investor that works for Fidelity Investments. Peter stated in his 1989 book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its growth rate". So a fairly valued company will have its PEG equal to 1. The lower the PEG the more undervalued a stock is based on future estimated growth.
A simple example using one of my favorite stocks, Intel (INTC)
- Currently has a P/E ratio = 11
- Expected 5 year growth rate = 11.6
Now we simply divide P/E by the expected 5 Year growth rate
- PEG Ratio = (11 / 11.6) = 0.95
So purely based on INTC's PEG ratio of 0.95, we can deduce that INTC is currently trading just under its fair value.
There is a major weakness to PEG ratio that I hope you see. There is no way to truly know a stocks future growth rate. We are relying on analysts' estimates in order to determine this number. Future growth of a company can change due to any number of factors: market conditions, expansion setbacks, a lack of innovation, market competition, etc... Since we are relying on estimates to determine this number, we should never solely judge a stock based on its PEG ratio. It does put a high value on future growth though, and this future growth is a very important aspect when deciding to buy a stock.