The PE/growth ratio (PEG) attempts to allow meaningful comparison of the prices of companies with different growth rates.
A faster growing company deserves a higher PE. The PEG ratio attempts to formalise this by dividing the PE ratio by the percentage annual growth in earnings per share.
The PEG ratio is:
PE ÷ g
where PE is simply the PE ratio
and g is the annual percentage growth in EPS.
It is usual to use historical PE and the growth from that to the prospective PE. So, if the historical EPS is 200p and the prospective is 210p, then g will be (210 ÷200) ×100 = 5. The use of the prospective PE and the following year's PE instead (i.e., all the numbers one year further forward) is also common.
The problem with this measure is that it only looks at the growth rate over one year, whereas with high growth companies it is their long term growth potential that matters. This makes it a rather crude measure that is more useful for screening rather than as a key measure for stock selection.
PEG assumes a linear relationship between growth and value (a company with twice the growth rate should have twice the PE). This is also incorrect, although it is a reasonable approximation when comparing companies with roughly similar growth rates.
The widespread use of short term measures such as the PEG ratio, is evidence that many investors focus on short term growth, and therefore tend to overvalue growth stocks whose growth tends to taper off over time. This is one of the explanations for the value effect