Finding out the real worth of a value pick is never a cakewalk. Certainly, the Price-to-Earnings (P/E) ratio provides investors with the easiest option to judge whether a company’s stock price actually justifies its current earnings. However, things are not as simple as they seem and considering P/E ratio alone may turn out to be extremely risky at times.

More elaborately, the P/E ratio, while not taking into account the future growth potential of a stock, may end up convincing us to invest in stocks that are at a discount just because of their poor show. For example, when the markets are weak, most of the fundamentally strong stocks fall within the discounted range in terms of P/E.

This may often lead to “value traps” — a situation when these value picks start to underperform over the long run as the temporary problems which once drove the share price down turn out to be persistent.

For investors looking to escape such value traps, it is vital to determine where the stock would be headed in the next 12 to 24 months?

Warren Buffett advises these investors to focus on the earnings growth potential of a stock. This is where lies the importance of a not-so-popular value investing metric, the PEG ratio.

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 to 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 of the first three years at a very high growth followed by a sustainable but lower growth rate in the long term.

Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are also taken into consideration.