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The PEG ratio is a simple tool that can be useful in your search for undervalued stocks. But it is far from a perfect metric and is no substitute for doing your own homework.

Before we examine its shortcomings, let's first explore what it is.

PEG Ratio Defined

The PEG ratio takes the basic price-to-earnings ratio one step further by factoring in earnings growth. In short, companies with faster earnings growth warrant higher P/E ratios.

This metric was first popularized by Peter Lynch and is calculated as:

Price/Earnings/Growth

According to Lynch, a company that's fairly priced will have a P/E ratio equal to its growth rate. In other words, a stock with a PEG ratio of 1.0 is fairly valued, while a stock with a PEG ratio of less than 1.0 is undervalued and a stock with a PEG ratio greater than 1.0 would be overvalued.

No Magic Bullet

While this seems intriguing and intuitive, remember it is only a rule of thumb. The assertion that a P/E ratio should equal earnings growth is somewhat arbitrary and certainly does not apply to all companies.

Consider a blue chip company operating in a mature industry. Its earnings growth may only be 5%. Does that mean it should have a P/E ratio of 5? What if it pays a huge dividend? What about a company with no growth... or even negative growth?

The intrinsic value of a business is the total of all its free cash flow available to owners discounted to the present value. This, of course, can be extremely difficult to calculate with any accuracy. So the PEG ratio is simply a proxy for it, and nothing more.

There is also no consensus on whether to use a trailing or a forward P/E ratio and whether to use next year's expected growth rate or a longer-term expected growth rate. But this can have a major impact on the PEG ratio calculation.

Beware Those 5-year Growth Rates

I would argue for using a forward P/E since the stock market is forward looking, along with a longer-term earnings growth rate to keep a long-term perspective. However, use the long-term earnings number only with a great deal of caution. That is because the long-term earnings growth rates that analysts publish are often way too optimistic.

A study by J. Randall Woolridge and Patrick Cusatis of Penn State showed that analysts consistently project EPS growth rates much higher than actual growth and that companies rarely meet or exceed their projected EPS growth rates. In fact, over a period of more than 20 years, Woolridge and Cusatis found that analysts' long-term EPS growth forecasts averaged +14.7%, but companies actual long-term EPS growth averaged only +9.1% - almost 40% lower.

The study also found that analysts almost never forecast negative long-term EPS growth, although it happens quite frequently.

So do your own homework, and make sure those growth rates seem reasonable. Because many bad investment decisions have been made based on off-the-wall earnings growth projections.

3 Deceiving PEG Ratios

So what are some deceptively attractive PEG ratios out there right now? Here are 3:

Apollo Group (APOL - Analyst Report)

PEG Ratio: 0.6
5-Yr Projected EPS Growth: 10.5%

Apollo Group owns several for-profit educational institutions including the University of Phoenix. A PEG ratio of 0.6 looks very attractive at first glance. However, if you look a little closer, enrollment, revenue, profit margins and earnings have all been moving in one direction for Apollo: down. In fact, based on current consensus estimates, analysts project a 20% decline in earnings for Apollo this year and a whopping 38% decline next year. It seems very unlikely that the company can get to 10.5% average EPS growth from there in just a couple of years.

Cirrus Logic (CRUS - Snapshot Report)

PEG Ratio: 0.6
5-Yr Projected EPS Growth: 16.9%

Cirrus Logic develops high-precision analog and digital signal processing components for consumer entertainment electronics, including smartphones. A high tech company with a PEG ratio of 0.6 might sound alluring, but based on current consensus estimates, analysts project a 32% drop in earnings this year and a 30% drop next year. The company would have to right the ship very quickly to see anywhere near 16.9% average EPS growth over the next 5 years.

Vale (VALE - Analyst Report)

PEG Ratio: 0.4
5-Yr Projected EPS Growth: 20.4%

Vale is a metals and mining company headquartered in Brazil. A PEG ratio of 0.4 might be tempting, but investors will probably be wise to ignore its siren call. Based on current consensus estimates, analysts project a 5% drop in earnings for 2013 and a 12% drop in 2014. And those estimates have been declining for several months. It's very unlikely that Vale can compound its earnings at an average of more than 20% from here when earnings are expected to decline this year and next.

The Bottom Line

The PEG ratio can be a useful rule of thumb for finding undervalued securities. But it should only be a starting place in that search. Don't blindly rely on those published 5-year growth rates and do your own homework!

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research and Editor of the Income Plus Investor service.

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