One of the calculations that we’ve found...

One of the calculations that we’ve found helpful for studying small, growing companies is what we call the Fool Ratio.

The Fool Ratio is based on a simple premise: In a fully and fairly valued situation, a growth stock’s price-to-earnings (P/E) ratio should equal the company’s annual earnings growth rate. (This is why it’s also called the PEG, for P/E-to-growth.) The P/E ratio is simply the stock’s current price divided by the company’s earnings per share for the last 12 months.

When the P/E and the growth rate are equal, the ratio is 1.00 and suggests a fairly priced stock. Ratios under 1.00 suggest undervalued stocks, while ratios greater than 1.00 suggest overvaluation. If a company has a P/E of 30, and its earnings are growing at 60% annually, you divide 30 by 60 and get an appealing 0.50 ratio. Meanwhile, if another company has a P/E of 11 and is growing at 6%, its ratio is 1.83. By this measure, the stock price appears steep.

Fool Ratios above 1.50 scare us, while those 0.50 or lower attract us. A ratio of 0.50 suggests that earnings are growing twice as fast as the stock price, and that the stock is trading at half its fair value. Such a company would be a prime candidate for further research.

Nifty though it may be, the Fool Ratio should serve as a general guide rather than a precise instrument. Remember that it focuses on earnings and doesn’t take into account important factors such as debt, cash, amortization, depreciation, and the full merits and shortcomings of a company’s business. It also doesn’t work with cyclical, financial, unprofitable, or large and established companies. Use it for growth companies with annual sales under $1 billion.

The Fool Ratio is explained in more detail at our https://www.fool.com Web site and in our new “The Motley Fool Investment Workbook” (Fireside, $12), available at your local library or bookstore. The workbook actually has you practice financial calculations as it guides you through them. Read more about the simple and handy Fool Ratio before using it.