The PEG ratio is one of the most popular valuation tools. It takes about eight seconds to calculate and is much easier than running a discounted cash flow valuation. But the skeptic in me started to wonder: Can something so simple really be useful?

I decided to back-test the PEG ratio to see whether it really is an accurate indicator of value. The results were surprising.

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Normally, I'd save the answer until the very end of the article, but let's just get this out in the open: On average, companies with lower PEG ratios outperformed those with higher PEG ratios by a wide margin over the past three years.

To me, that indicates that the PEG is not just a lot of smoke and mirrors. Although it is not a perfect tool (what is?), it is useful for a quick and dirty valuation.

PEG crash course
Before we crunch some numbers, here's a quick refresher on the PEG ratio. Simply divide the P/E ratio by the rate at which you think earnings will grow over the next few years. You can use your own growth estimates or get five-year analyst growth estimates from Yahoo! Finance. If your PEG is around 1, you have a fairly valued company -- or so the legend goes. A PEG much higher than 1 indicates an overvalued company, and a PEG lower than 1 indicates an undervalued company.

Now, the fun part
I calculated the PEG ratio as of March 2003 for more than 1,000 companies. I simply took the P/E ratio in March 2003 and divided it by the actual earnings growth rate from March 2003 through March 2006.

Then I calculated the performance of each stock over the past three years to see whether I could find any correlation between the PEG and stock performance. On average, stocks with a 2003 PEG between 0 and 1 performed much better than the others. Here are the results.

2003 PEG Ratio

Number of Companies (1,316 total*)

Median Return

Average Return

Below 0.00

213

43.9%

69.4%

0.00 - 0.99

583

154.1%

225.2%

1.00 -1.50

193

78.4%

92.6%

1.51 - 2.00

102

60.5%

79.0%

More Than 2.00

225

44.4%

69.4%

*Includes U.S. companies trading on major exchanges with market caps greater than \$500 million for which data was available.

My study is not statistically airtight. The results are skewed by having to throw out companies that had negative earnings. However, my sample size is large enough that I feel comfortable calling these results a good guideline for the PEG ratio.

Some things to ponder
Here are a few more interesting tidbits from my study:

• 92% of companies with PEG ratios of less than 1 beat the market over three years.
• 68% of companies with PEG ratios of between 1 and 2 beat the market.
• 47% of companies with PEG ratios greater than 2 beat the market.
• The best performer was (surprise, surprise) Hansen Natural (NASDAQ:HANS). It had a PEG of 0.08 in 2003 and had gained 5,400% through March.
• The second-best performer was NutriSystem (NASDAQ:NTRI) with a PEG of 0.06 and a gain of 5,200%.
• Despite a PEG of 0.55, Ford (NYSE:F) managed only a 14% gain over three years.
• Dick's Sporting Goods (NYSE:DKS) was "fairly valued" with a PEG of exactly 1, but it still appreciated by 265%.
• A PEG of 8 didn't stop Select Comfort (NASDAQ:SCSS) from appreciating by 266%.

Caveats
The PEG ratio is limited by its focus on earnings growth. For example, Ann Taylor Stores (NYSE:ANN) grew earnings at -0.32% over the past three years, but the stock tripled. Altria (NYSE:MO) also had negative earnings growth, yet the stock doubled.

These performances point out the shortcomings of the PEG -- earnings growth is not the only thing the market cares about. Revenue growth, cash flow, dividends, debt, and many other factors are also important to value.

Another thing to consider is that the "G" is the crucial part of the PEG. I was able to calculate the exact rate of earnings growth when back-testing. But when you are trying to value a company today, you won't know the rate of earnings growth. You will only have your best guess, or the best guess of Wall Street analysts. Thus, your PEG will be only as good as your inputs.

Finally, the PEG is very useful for small growers like Hansen and NutriSystem, but may be misleading for large, mature companies like Altria and Ford, since sustained growth is less important to their total returns.

Foolish bottom line
I hope my study helps to shine some light on the pros and cons of the PEG ratio. Keep in mind that the PEG is most useful when used to supplement a more thorough discounted cash flow analysis or relative valuation.

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Select Comfort is a Motley Fool Hidden Gems recommendation.

Fool analyst Joey Khattab does not have a position in any of the companies mentioned.You can only hope to contain the Fool's disclosure policy.

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.