The PEG ratio, made popular by investor Peter Lynch, fixes a blind spot in the P/E ratio: P/E tells you how expensive a stock is, but it ignores how fast the company is growing. A P/E of 20 looks pricey on its own, but if profits are growing 30% a year, it is actually cheap for that growth. PEG captures both in one number by dividing the P/E by the growth rate. In that example, a P/E of 20 divided by 30% growth gives a PEG of about 0.7.
As a rough guide, a PEG below 1 is attractive (and a real bargain under 0.5), around 1 is fairly valued, and above 2 is expensive.
A few warnings. PEG only makes sense when profits are actually growing, so it is useless for a shrinking business. Always use a growth rate measured over several years rather than a single year, which can be a fluke. And treat very fast growth of 50% or more with caution, because it rarely lasts, and a PEG built on it will flatter the stock and make it look cheaper than it really is.
Our number uses the company's earnings-per-share growth compounded over the last five years, not a single year, so a one-off spike or dip does not distort it.