Here is a great article that talks about PEG ratios: -->
Archive Headline
23-Feb-01
So What Exactly Represents an Attractive PEG? [BRIEFING.COM - Michael E. Ashbaugh] The PEG or Price/Earnings to Growth Ratio is commonly used
as a valuation benchmark for determining relative differences in the value of alternative investments. As a general rule, conventional wisdom says a PEG under 1.0
is attractive whereas a PEG over 1.0 may be something to shy away from. In other words, if the P/E is smaller than the growth rate it's a good investment. If the
inverse is true, you may want to be careful. But is this accurate?
The Ingredients: P/E Ratio and Growth Rate
Price/Earnings
From a mathematical perspective, the Price/Earnings Ratio and the underlying Growth Rate of a business are completely unrelated. The P/E is exactly as defined.
It's the share price divided by trailing-twelve-month earnings. Or alternatively, the P/E could be defined as the market cap divided by the trailing-twelve-month net
income. Either way you define it, the P/E ratio utilizes two identifiable variables to arrive at a concrete output which summarizes those variables.
As a consequence, the P/E ratio is a static indicator in the sense that it relies on two historic and quantifiable data points: 1) earnings (trailing or projected) and 2)
current share price. Even when utilizing a forward P/E the static nature of the output doesn't change, only the point in time that is referenced does. As a static
indicator, the P/E ratio is backward looking in the sense that it doesn't account for relative differences in growth. It's a reasonably straight forward thought process
to see that the P/E represents the multiple of the current year's income.
Growth Rate
Now the growth rate is more straight forward. This is a projection of anticipated growth for a hypothetical period of time. Frequently a one-year or five-year growth
rate are projected on any given business' prospects going forward. This data point is forward-looking if appropriately utilized.
So What Happens When You Combine a Forward Looking Data Point With Backward Looking Data Point?
The common misconception regarding the PEG or Price Earnings Ratio/Growth Rate is that it captures the growth component of valuation. This is generally true
where the growth rates of the two test businesses are similar or the same. Yet where this is the case, incorporating the growth rate into a comparative valuation is
largely an exercise in redundancy. In other words where growth rates are the same, taking the P/E ratio and using the same divisor for each ratio does little to alter
the assessment aside from providing different numbers to compare.
The important aspect of growth in the valuation metric is it's impact in terms of compounding revenue or income over time. Plugging the growth rate into a new
formula to derive a new ratio doesn't get to the meat of the growth component of value. It simply provides a new and different benchmark by which to assess a
business. To answer the question directly, when you combine a forward looking data point with a backward looking data point you derive another static or backward
looking data point. We'll see how that happens with a comparison of two businesses.
So let's take the PEG for a test drive and see how it runs.
High PEG Relative to Low PEG
Let's take a look at two businesses with differing growth dynamics and see whether the PEG captures the growth component of value. The PEG is typically utilized
to compare two companies in the same sector. This being the case, each sector will have somewhat different bands that define the norm for a particular sector.
However, even within an industry growth rates and margin dynamics can differ substantially. To accentuate the impact of these differences, let's compare two
businesses in different sectors. The random business generator has spit out Nordstrom (JWN) and Sun Microsystems (SUNW). Here's how they look...
Company
Nordstrom (JWN)
Sun Microsystems (SUNW)
P/E Ratio
18.2x
30.2x
Growth Rate
13%
21%
PEG Ratio
1.40
1.43
Operating Margins
4.5%
13.9%
A quick read on the relative PEG's of these two businesses would indicate the two investments are roughly at parity. Nordstrom trading with a PEG of 1.40 is
essentially the same as buying Sun Microsystems PEGed at 1.43 right? Not exactly.
Growth
Despite the fact that PEG includes growth as a component of it's formula, the impact of growth on value is not captured at all. For instance, look at how $1 of
revenue for SUNW is going to grow relative to $1 of revenue for JWN. We'll use a five-year time horizon which fits with our long-term growth projections.
SUNW (1*1.21)^5 = $2.59
JWN (1*1.13)^5 = $1.84
Now subtract the original $1 of revenue for each and you'll have the growth in each investment.
SUNW will generate $2.59 - $1.00 = $1.59 of growth over five years
JWN will generate $1.84 - $1.00 = $0.84 of growth over five years
Now this demonstrates how the PEG has mislead us. Relative to Nordstrom, Sun Microsystems is expected to generate almost twice the revenue growth over the
next five years. Again, a quick glance at the PEG suggested these two investments were at parity. In other words, the PEG indicates that either investment would
garner a similar return with alternative levels of risk. The fact of the matter is SUNW will generate twice the revenue of JWN with alternate levels of risk.
Operating Margins
Interestingly, SUNW's operating margins are roughly three times those of JWN. So how does this play into the mix? Let's take a look.
For SUNW, $1 of current revenue will generate $1.59 in new revenue over the next five years. With operating margins of 13.9%, SUNW will generate $1.59 *
0.139 = 0.22. That's 22 cents in operating earnings for every $1 of current revenue.
For JWN, $1 of current revenue will generate $0.84 in new revenue over the next five years. With operating margins of 4.5%, JWN will generate $0.84 * 0.045 =
.04. That's 4 cents of operating earnings for every $1 of current revenue.
The point of all this is when differences in operating margins are accounted for, the valuation difference favoring SUNW is exacerbated.
Then What's The Point?
Don't assume the PEG always captures differences in growth. Where the underlying growth rates of two businesses are substantially different it is probably better
to set aside the PEG and take another valuation tool out of the box. Similarly, if operating margins differ in a meaningful way, use another metric.
Please don't misread these comments about our trusty PEG. The point here is not that the PEG has no value as a tool for ascertaining differences in valuation. The
point is this: it's necessary to assess the PEG in the context of growth rates and margins in order to truly have a handle on the relative differences between two
prospective investments. If the growth and margin dynamics are reasonably similar the PEG is likely a safe tool to use for benchmarking. PEG does not magically
account for differences in growth rates simply because it plugs growth into an artificially created formula. Just as the P/E can be misapplied and misunderstood, the
PEG is susceptible to the same issues as well. |
