The PEG ratio compares a stock’s price (as measured by the price-to-earnings ratio or P/E) with its earnings growth. When used correctly, PEG can help you find great companies.

But I suspect that these days it’s misused more often than not.

P/E is one of several metrics that can help you get a handle on how expensive or cheap a company is. A PEG of 1 or less means good growth for the price. Above that, and the stock is probably overvalued.

I used to love PEGs of 1 or less. Whenever I saw one, I wrote in the margins of my notebook, “High growth expected.”

Two years ago, this notation always meant “Good. The company is on a high-growth trajectory.” When I write the same thing now, it means something entirely different. I think, “Gee, can this company meet its high-growth expectations?”

Let’s take a look at Coke.

The forward P/E (based on expected earnings for the next 12 months) for the entire S&P 500 index is 12.42. Coke’s is 13.02.

If Coke were expected to increase earnings at a rate of 13.02 percent a year over the next five years, its PEG (P/E divided by earnings growth) would be exactly 1.

With a 13.02 P/E, the last thing I want is a PEG of 1 or less. In such a case, the company would be expected to grow earnings by at least 13.02 percent a year. And in this global environment, that would be next to impossible.

But Coke’s PEG isn’t 1. It’s 1.69. That makes its projected annual earnings growth a very achievable 7.7 percent.

The stock market is all about expectations. When a company disappoints analysts and investors, it can lead to a decrease in its share price.

With a PEG of 1 or less, that’s a probable outcome these days. I don’t go there anymore – and neither should you.

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Andrew Gordon

Andrew Gordon is a former editorial contributor for Early To Rise Investor’s Edition. He has 20 years of experience working in infrastructure and environmental projects around the world. When he wasn't traveling, he taught marketing and finance courses at the state university of Maryland. Mr. Gordon has authored several books for McGraw Hill and other publishing companies on energy markets, global countertrade practices and the hot growth sectors of China and Russia. He is also a top-rated speaker at financial conferences.

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