The popularity of value investing is on the rise. The success of billionaire value investors like Warren Buffett further underscores the fact. Over the past five years, his conglomerate Berkshire Hathaway’s book value has grown at a compound annual rate of 11% (The Economist). Per a July Motley Fool article last year, over the past 50 years, the stock has yielded a compound annual return of 20.8%. This indicates that an investment of $10,000 in 1965 would be worth $88 million today.

However, apparently simple to understand, this investing discipline has its own share of pitfalls. A value investor mostly misses the chance of betting on stocks that have bright long-term prospects and in their quest for cheaper stocks, they often end up picking stocks that have weak prospects.

Buffett believes that a proper understanding of the “intrinsic value” of a stock may ease out many problems with regard to value investment. According to him, going by the fundamentals of value investing while picking undervalued stocks, investors need to focus on their earnings growth potential.

While yardsticks such as dividend yield, the ratio of price to earnings, sales or book value are the most common value investing metrics that can single out stocks trading at a discount, these ratios fail to consider the potential of a stock. PEG is the ratio with the earnings growth component in it.

The PEG ratio is defined as: (Price/Earnings)/Earnings Growth Rate

A lower PEG ratio is always better for value investors.

While P/E alone fails to identify a true value stock, PEG helps find the intrinsic value of a stock.

Unfortunately, this ratio is often neglected due to investors’ limitation to calculate the future earnings growth rate of a stock.

There are some drawbacks to using the PEG ratio though. It doesn’t consider the very common situation of changing growth rates such as the forecast for the first three years at very high growth, followed by a sustainable but lower growth rate in the long term.