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We can compare the P/E of each stock to the average multiple in their respective industries, and in fact one should, since that might help give one a sense of their relative value. But one may still be dealing with two very different companies at completely different stages of evolution,
and a one-size-fits-all P/E ratio comparison isn't going to help that much. That's where the PEG comes in.

In a way, the idea of the PEG ratio is to compare the earnings of a company to itself, that is, to compare the P/E of a stock to the company's internal growth rate, with fair value in the range of a one-to-one ratio. In other words, if a particular company can only manage to increase its earnings at 10 per cent per year, then its stock is arguably only worth 10 times earnings; if a company can produce growth of closer to 30 per cent per year, then its shares arguably deserve to trade at close to 30 times earnings.

Moving on to PEG (Price Earnings to Growth) Ratio

PEG is a widely used indicator of a stock's potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. The usual ratios of earnings, reve to price doesn't tell if a company is "expensive" or really a future growth company. The PEG ratio can perhaps tell something more about if a company is just "expensive" or really has a bright future of growth and expansion.

Thus, relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. This is called the PEG Ratio and is formulated as: -

PEG Ratio = Price Earnings Ratio / Annual EPS Growth

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* Contributed by: -
Varun Dawar,
PGDBM, Batch 2004-06,
Institute of Management Technology (IMT), Ghaziabad.