I recently learned that hot water can freeze faster than cold water. Perhaps you already knew this but it was news to me. It’s a phenomenon known as the Mpemba Effect.

This Mpemba Effect seems counterintuitive. Water freezes at 32 degrees. Since cold water is closer to 32 degrees than hot water, most would assume that cold water freezes first. Yet it has been studied extensively by scientists and experiments have shown hot water can freeze first. This isn’t true 100% of the time, but it does happen when the conditions are right.

There are a number of theories about why this occurs. The leading explanation is that hot water evaporates more than cold water, leaving less water to freeze. It could also be due to convection currents, which are stronger in warmer water, allowing for ice crystals to spread faster. Others believe it may be related to the chemical structure of water. In all likelihood, it is the interplay of various factors.

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You might be asking what this has to do with investing. To me, the Mpemba Effect illustrates that logic alone may not be enough to find the right answer. You have to dig deeper to understand the relationship between variables in any problem. This is true in science and investing.

For example, value investing is based on the simple premise of buying undervalued stocks, but “undervalued” can be defined in a number of ways.

The price-to-earnings (P/E) ratio is one of the most popular ways to define value. If a stock is trading with a P/E ratio of 10, investors are paying $10 for each $1 of earnings in the company. If the P/E ratio is 20, investors are paying $20 per $1 of earnings. Considering only this factor, the stock with the P/E ratio of 10 would be considered the better value. Since we expect undervalued stocks to outperform the market in the long run, buying the stock with the lower P/E ratio is the logical choice.

But sometimes the stock with the P/E ratio of 20 will actually be the better value. Just like with the Mpemba Effect, a number of variables could affect the outcome. A stock’s P/E ratio needs to be considered in relationship to how fast the company is growing earnings.

The PEG ratio is a metric that compares the P/E ratio to the earnings per share (EPS) growth rate. It offers a way to determine what the P/E ratio for a stock “should” be, therefore helping us determine whether it is undervalued.

Analysts assume a stock is fairly valued when the PEG ratio is equal to 1. This occurs when the P/E ratio is equal to the EPS growth rate. PEG ratios below 1 indicate a stock is undervalued, and PEG ratios above 1 indicate a stock is overvalued. Of course, this is just one valuation tool, but it gives some much-needed context to the P/E ratio.

Going back to the example above, if the stock with the P/E ratio of 10 is growing earnings at 7% a year, its PEG ratio would be 1.4, indicating it is overvalued. If the stock with the P/E ratio of 20 is growing earnings at 25% a year, its PEG ratio would be 0.8, signaling it is undervalued. Basically, the PEG ratio recognizes that stocks with higher EPS growth rates deserve to trade with higher P/E ratios.

The PEG ratio also helps me quickly find a stock’s estimated fair value. I start with the basic formula:

As I mentioned above, a stock is considered to be trading at fair value when its PEG is equal to 1. Therefore, to find the fair value estimate for a stock, we can rewrite the formula as follows:

Let me show you how I use it with a recent trade example.

In early April, I recommended a position in Tesoro Corporation (NYSE: TSO). While most oil-related stocks had been decimated as crude prices plunged, this refiner had actually been among the stock market leaders — an absolutely astounding feat.

At the time, shares were trading around $85.25. TSO had a P/E ratio of 11 based on 2015 estimated EPS of $7.80, and analysts expected average EPS growth of 11.6% a year.

Using the PEG ratio to determine fair value, I multiplied the $7.80 in earnings by the 11.6% EPS growth rate to get $90.48. This was 6% above where TSO was trading, but I saw a chance to buy TSO at a nearly 19% discount using my favorite income strategy.

I sold a put option on TSO that obligated me to buy shares if they were below $70 on May 15. Now, given TSO’s recent relative strength and $90-plus fair value, I did not think a drop to $70 was likely, but had it happened I would have viewed it as a screaming bargain.

So why would I enter this trade? Well, in return for accepting this obligation, I was paid a premium of $0.68 per share of TSO that I agreed to purchase at a steep discount. Since each option contract controls 100 shares, I actually received $68 per contract I sold.

Buying 100 shares of TSO at $70 each would cost $7,000, and my broker required me to deposit 20% of that obligation in my account, or $1,400.

After a small dip following my initial recommendation on April 9, shares headed higher and remained well above $70 through the option’s expiration. So on May 15, the premium was mine to keep, resulting in a 4.9% return on my $1,400 margin requirement. That may not sound that exciting but consider the following points:

1. I earned this money without ever having to buy shares of TSO.

2. The biggest downside to this trade was that I might have to buy shares of a stock my analysis showed was already undervalued at an even bigger discount.

3. That return was made in just 37 days, which works out to an annualized gain of 47.9%.

I am actually closing in on my 100th winning trade using this extremely lucrative strategy. Over the past two and a half years, every trade I’ve closed has been profitable.

I put together a step-by-step tutorial that details how I’ve been able to achieve this. If you’re interested in learning more or following my trade recommendations, follow this link.

This article was originally published on ProfitableTrading.com:This Phenomenon Could Change the Way You Look at Value Investing ​