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To understand how PEG works, you need to understand how the P/E ratio works. A company’s P/E ratio is calculated by dividing the market price of a single share of company stock by earnings per share. The higher the P/E ratio, the more expensive the stock is considered to be. For example, if a stock has a P/E ratio of 10, it means its share price is 10 times higher than its earnings per share.

The PEG ratio is calculated by dividing a company’s P/E ratio by its annual earnings per share growth number. Like the P/E ratio, a low PEG ratio indicates the price of the stock is cheap compared to its earnings. In this case, however, the lower the PEG ratio, the cheaper the stock price is compared to its rate of earnings growth as well.

Cheap and expensive are relative terms when it comes to valuating stocks. There is no particular PEG or P/E ratio number that tells you a stock is cheap. However, if you compare these ratios to ratios of other companies in the same industry, it can give you a better idea how cheap or expensive a stock is relative to its competitors.

As with any stock valuation tool, buying stocks with low PEG ratios is not a guaranteed way to investment success. It is a useful tool to help you compare stocks, but it does not tell you everything you may want to know about a company. For example, it does not take into account dividend payments, and it punishes low-growth companies that pay steady dividends, such as Coca-Cola and Johnson and Johnson.