What does valuation mean to you? For some investors, the word valuation conjures up images of spreadsheets packed with data and variables about what might happen in the future. For others, the word is a stand-in for certain rules of thumb or methods for figuring out whether a stock is worth its current quoted price.

For example, many investment professionals exhibit the strange Wall Street talent of being able to reel off coming-year earnings per share estimates for dozens of companies like a third-grade student reciting multiplication tables from memory. Toss in a "multiple" on those estimates, and the pro suddenly has a year-end price target for the stock in question. While fairly simplistic and sometimes outright silly, such a process gets passed off as serious "valuation work" in sell-side research reports all of the time.

An even more popular extension of this latter valuation method involves comparing a company's multiple to its earnings growth rate, an analytical shortcut known as price-to-earnings-growth or PEG. We briefly introduced the concept of PEG in last week's column on valuation tools for stocks with relative share price weakness.

Much of PEG's allure centers on its simplicity. All an investor needs is a company's price-to-earnings (P/E) ratio and an earnings growth rate, which can be the growth rate over the past fiscal year or (more commonly) the growth rate projected by analysts over the next few years. With both of these figures in hand, the individual investor can then go around and start PEG-ging every publicly traded business out there.

The idea behind PEG is that the closer the earnings multiple and growth rate are to each other, the closer the company is to what is perceived to be fair value. For instance, if a stock currently sports a P/E of 16 and is expected to grow its earnings at a 15% rate over the coming years, the current valuation would be deemed reasonable to a PEG practitioner. Too high of a P/E in relation to the growth rate, and there is the risk the stock is overpriced. The cutoff ratio varies among individuals, but the general belief is a P/E that is 1.3 to 1.5 times the growth rate or more suggests an overpriced stock.

The popularity of PEG is mostly borne out of the investment business' infatuation with the P/E ratio as the stock valuation indicator par excellence. That's a suspect notion by itself, as the P/E should be properly viewed as a reflection of business value (and an imperfect one at that) and not as somehow a determinant of value. In other words, there is no rule in the stock market that states that a company with a starting P/E of five is automatically more likely to see its multiple double down the road than a firm with a starting P/E of 20, just because five is a lower base than 20. The past five or six years of stock market history are riddled with examples dispelling this belief. 

And it gets worse. As it turns out, the P/E infatuation is fueled by the even more prevailing focus by investors on reported earnings as the end-all, be-all factor in business value creation. Of course, the major problem with this ongoing love-fest is that accounting earnings can be manipulated in any number of ways. In the extreme, reported earnings can turn out to be an outright fraud, as in the Cendant (NYSE: CD) debacle of 1998. More often, they are an imperfect reflection of a company's underlying economics, which is the case for many financial companies and insurance companies in particular. There can be other highly criticized potential potholes in a company's reported earnings as well, such as the understatement of stock option-related expenses or the use of inappropriate depreciation and amortization schedules.

The fallibility of reported earnings is enough of an indictment for PEG by itself, but the weakness of the "G" in the PEG abbreviation really seals the deal in my mind. Most PEG users rely on sell-side analyst estimates for long-term growth rates, which is a tremendously risky practice. For starters, some analysts have openly admitted that these estimates are made up. And moreover, it doesn't seem that any self-respecting analyst can come up with a long-term growth rate of less than 15% for any company, regardless of its industry, competitive positioning, or future outlook. This is a complete farce, judging from historical studies that reveal just how few companies are able to sustain a 15% or greater average annual earnings growth rate for a significant length of time.  

In my opinion, the growth rate problem is the ultimate irony of relying on PEG as a single-shot valuation tool for risky assets. This includes fast-growing, small company stocks, where the desired "long-term" holding period may only be a few years. In reality, it's over the much longer term -- five to 10 years or more -- that PEG has the best chance of performing as advertised. There's little doubt in my mind that an investor who buys a company at 15 times earnings and then watches that company go on to grow its cash earnings 15% annually for a decade or more will do very well in the end. The problem lies in first trying to find a company that will reliably achieve that growth rate over such a long span, and then buying it at such a low P/E ratio.

For small-cap investors, relying on PEG as the sole valuation tool is a risky proposition. In fact, relying on any quick rule of thumb as a proxy for "valuation work" is asking for trouble. Ideally, valuation should involve looking at a company and its prospects in as many different ways as possible. That may mean there is no compelling reason why a PEG analysis shouldn't be one model an investor uses to think about stock valuation. But in the same vein, there is no compelling reason that it should be the only model either. 

Brian Graney is very grateful for the wonderful math teacher who taught him the multiplication tables in third grade -- thanks Mrs. Barrett! At the time of publishing, he did not hold shares of any of the companies mentioned above. The Motley Fool is investors writing for investors.