Stocks come in all shapes and sizes. Some are worth hundreds of thousands of dollars; some trade for pennies. This enormous gap can make apples-to-apples comparisons challenging. 

One way to overcome this problem is by comparing stock ratios rather than stock prices. Using these valuation metrics, investors can see how expensive a stock is, no matter how high or low its price.

But with so many valuation ratios to use, they can be intimidating terrain for many investors. Today, I want to explain one: the PEG ratio.

We'll cover its significance, how it varies by industry, and why it's flashing buy signals for Alphabet (GOOG -1.22%).

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Image source: Getty Images.

What is a PEG ratio?

The price/earnings-to-growth ratio (PEG ratio) is one of my favorite valuation metrics for stocks. What I find so useful about this metric is that it includes not one, but two of the most important financial factors for a stock:

  • Earnings-per-share (EPS)
  • Earnings-per-share growth

To really understand how the PEG ratio works, we must examine its valuation metric cousin, the price-to-earnings (P/E) ratio. The P/E ratio helps us standardize and compare stocks by dividing their share price by their full-year EPS. 

To see this in action, let's first use Apple as an example. Take Apple's stock price ($148.67), then divide it by Apple's EPS for the past 12 months ($6.15). This results in a P/E ratio of 24.2. Since we used EPS from the past 12 months, this P/E ratio is called a trailing P/E ratio. If you used the EPS estimates for the next 12 months, that ratio would be a forward P/E. 

To calculate a stock's PEG ratio, you must divide the trailing P/E ratio by the stock's EPS growth rate. Calculating earnings growth is tricky because it involves projecting a stock's EPS several years into the future. Nevertheless, Wall Street analysts spend millions of hours every year producing EPS estimates. For large companies, there are usually dozens of estimates -- out of which an average (i.e., consensus) estimate will emerge. 

Sticking with our example, Apple's consensus EPS growth rate is around 9.3%. So, if you divide Apple's P/E ratio (24.2) by its consensus EPS growth rate (9.3), you'll get its PEG ratio of 2.6.

What's a good PEG ratio?

Broadly speaking, a good PEG ratio is between 0 and 1.0. This indicates a stock that's showing growth at a reasonable price. PEG ratios slightly above 1.0 indicate stocks where P/E ratios are running ahead of earnings estimates, and very high (or negative) PEG ratios can indicate that a stock is overvalued.

The S&P 500, a broad index of 500 large U.S. companies, has a PEG ratio of 1.2. However, that ratio has varied from a low under 1.0 earlier this year to a high of 2.4 in 2020. 

There are also differences between sectors. Utilities (2.9), consumer staples (2.6), and healthcare (2.0) have the highest PEG ratios today. Meanwhile, energy (0.3), consumer discretionary (0.8), and communication services (1.0) have the lowest. The technology sector, the largest and arguably most important sector, has a PEG ratio of 1.3.

Why Alphabet's PEG makes it a buy now

Now let's consider Alphabet. The company's (trailing) P/E ratio is 21.0. Its consensus EPS growth rate is 25.5, giving it a PEG ratio of 0.85.

This sub-1.0 PEG ratio means that Alphabet is below both the market average of 1.2 and its sector average of 1.3 -- implying the stock is undervalued. This conclusion is supported by the stock's P/E ratio, which remains near historic lows. Alphabet's shrinking P/E ratio helps explain Alphabet's low PEG ratio, because a stock's P/E ratio is the numerator in its PEG ratio. 

GOOG PE Ratio Chart
Data by YCharts.

In a nutshell, Alphabet's stock price has come down, while its recent earnings (and future earnings expectations) have not. As a result, the company's PEG ratio is passing along a crystal-clear message: Alphabet is cheap, and it's time to buy.