In order to understand if the company is overvalued or not, the quickest way is to look at the P/E ratio and compare it with the industry average of P/E. If P/E is larger than that of the market, the stock is said to expensive. But according to Peter Lynch, "The P/E ratio of fairly priced company will be equal to its growth rate." Because, the company is growing faster than the average industry would have P/E greater than the industry average. The company with superior growth rate deserves higher valuation and should not be considered overvalued. This concept is captured by peg ratio.
So consider for example, company A, B and C with respective P/E ratios 35, 20, 20. One might think that company A looks expensive but if the growth rate for the companies are 40%, 15%, 20% then the peg ratio will be 0.88 for A, 1.33 for B and 1 for C, which indicates that A is undervalued as compared to its growth potential.
Thus peg ratio under 1 is said to be a good value to invest in the company. P/E is generally higher for the companies with high growth rate, which then appear overvalued compared to others but that may not be the case with peg.
Peg ratio takes into account the future growth rate but the same growth rate is not going to last forever. It does not suggest how long will the ratio persists. It undervalues companies with extremely high or exponential growth rates. Peg works less for large cap companies which by nature are grow slowly and gradually but have a strong future prospect.
Also using historic values of EPS, it would provide an inaccurate peg. It is considered preferable to use future value. To distinguish between the future and the past value of growth rate, the terms "forward PEG" and "trailing PEG" may be used.
Hence with both advantages and criticism associated with the ratio, it is not a “be all and end all” measure, but provides a yardstick to identify undervalued securities.
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