Ah, the PEG ratio. An approach to valuation celebrated by lovers of growth stocks, including some at the Fool, the PEG ratio is typically defined as a company's trailing P/E ratio divided by analysts' five-year estimates of earnings growth. The ratio has won over many fans because:

  • The inputs can be quickly and readily found on nearly any financial site.
  • It is relatively intuitive.
  • It doesn't require any complex math.

Conventional wisdom states that if a company's P/E ratio is roughly on par with its growth rate, its stock is about fairly valued. If a company's growth rate is higher than its P/E ratio, the stock would appear to be undervalued, and vice-versa.

But there's a catch
The PEG ratio is like Sonny Corleone: Too simple for its own good, and as a result, riddled with holes. To me, the PEG ratio merits about as much consideration when it comes to valuation as tomorrow's weather forecast. Here are seven reasons why.

1. It relies on the P/E ratio
As we've espoused oh-so-many times here before, free cash flow, not earnings (an accounting measure), truly drives economic value. Earnings represent paper profits that can be easily (and legally) manipulated, whereas free cash flow represents bankable profits that can be used to shore up balance sheets, repurchase shares, or pay dividends.

So why not use a price-to-free cash flow multiple in place of the P/E? At that point, you're comparing growth rates of two separate financial measures (free cash flow vs. earnings) and statements (cash flow statement vs. income statement). Apple, meet orange.

2. It looks both ways
Speaking of unmatched fruits, the PEG's numerator and denominator face in opposite directions. The P/E ratio is backward-looking, while analysts' growth estimates are forward-looking. There's a bit of a logical disconnect there, and that asymmetry flares up like an ulcer when you're looking at stocks with volatile earnings.

So why not use a forward P/E? That's certainly a step toward symmetry, but what stock doesn't look cheap when you use a forward P/E?

Take Google (NASDAQ:GOOG). With a trailing P/E of 29 and analysts estimating annualized earnings growth of 30%, Google has a PEG right around 1. But if you replace the trailing P/E with Google's forward P/E of 18, the PEG dips to about 0.6. Suddenly, Google looks like a screaming buy. Using a forward P/E in the PEG ratio strikes me as an awesome way to rationalize just about any purchase.

3. It punishes low-growth stocks
If you buy into the concept that a company's P/E ratio and forward earnings growth should be roughly equal, then how should we play low-growth stocks? At the extremes, that would suggest that a no-growth stock would have no value, or that names like Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) should only command single-digit P/E multiples.

4. It ignores dividends
To the detriment of all dividend payers, such payouts are not reflected in the PEG ratio. When a company pays out a dividend, it forgoes reinvesting that cash in its business to fuel future earnings growth. As a result, any growth estimate likely understates a dividend payer's true ability to generate shareholder value. It also means that that low-growth, high-yield stocks will almost always look overvalued via the PEG ratio. That's ironic, given the empirical research showing that investing in such companies is a market-crushing strategy.

5. Five-year estimates are bunk
Studies have shown that analysts are consistently too optimistic when it comes to estimating earnings growth. A recently completed 20-year study reviewed the accuracy of analysts' five-year earnings growth estimates, pegging the average estimate at 14.9%. For those of you scoring at home, that's several times the historical rate of U.S. GDP growth, and about 1.5 times the market's historical return. Pretty illogical, right?

Right. Turns out the average actual annual growth rate for the companies in the sample was only 9.8%. If you're relying on unadjusted analysts' estimates as a key factor in your valuation, you're cooking with bad ingredients.

6. Sample sizes vary
While financial websites readily post five-year average analyst estimates, they don't happen to mention how many analysts contributed to that average. Sound trivial? Often, only one analyst comprises the entire sample of estimates. Without doing further digging, that means you're pinning the key driver of your valuation on a single analyst whose name, firm, and track record you do not know. Yikes!

7. There's no consideration for risk
Consider the PEG ratios of First Solar (NASDAQ:FSLR) and PepsiCo (NYSE:PEP): about 1.4 and 1.9, respectively, at yesterday's close. Without further context, a PEG-centric thinker would conclude that First Solar is the better buy. But the PEG ratio doesn't reflect that First Solar's business risk and share-price volatility both vastly outweigh those of PepsiCo. Investors who lean on the PEG as a crutch without considering varying risk profiles are cruising for a bruising.

The endgame
Trust me, I could keep going; I didn't even touch on how the PEG is a linear ratio containing a non-linear input, or how it doesn't control for differing durations of supernormal growth. But enough blathering.

What are the takeaways here?

  • Focus on cash flows, not earnings.
  • Don't rely on analysts' estimates.
  • Never let business risk fail to be a factor in your valuation.

Oh, and did I mention to avoid using the PEG ratio?

Read more about the PEG ratio:

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.