The PE to Growth (PEG) Ratio is defined as:
PE
PE to Growth (PEG) = ----------
EPS Growth
This ratio is based on the assumption that it is reasonable for the PE value of a company that has rapidly growing earnings to be greater than the PE value of a company that has slowly growing earnings. Intuitively that seems reasonable. However, it is reasonable to ask: Is the relationship between PE and Growth really this simple?
BACKGROUND A number of articles have been written concerning an appropriate value for PEG (but I am not prepared to quote a specific example). I remember reading one article that said a study of many companies over many years showed that PEG averaged about 1.5 and seemed to range between 1 and 2. Another article in the Wall Street Journal stated that "price hits a wall" when PEG gets above 1.
Does anyone have any thoughts about this? I have tried to find an article containing a derivation showing why PEG is a valid measure of value. So far I have not been successful. Maybe PEG is a rule-of-thumb relationship supported by historical data. I do not know.
The current "conventional wisdom" seems to be that it is desirable for PEG to be less than 1.
USING PEG When you see a published value for PEG you should ask yourself: What PE and Growth rate were used? The discussion of the PE ratio in part 5 pointed out some of the uncertainty involved in the PE calculation. Also, the selection of a future growth rate is often very subjective. The selected growth rate could be selected based on historical data, the next full year estimate, the next 5-year estimate, etc. As such, it is often possible to rationalize almost any value of PEG you want. In order to calculate PEG, what judgment would you utilize to select a PE value and Growth value?
Recently Jim Dickerson posted the following comment on the NAIC forum:"I think the logic behind using PEG <= 1 as a basis for buying a stock is that you should not pay at a higher current PE than a stock is projected to grow in the future. I believe, historically, PE's usually match growth rates. The PEG ratio is just a way of saying how much the market is willing to pay for the future growth of a company. It should be highest for financially stable companies with predictable earnings growth rates. Rather than using PEG<=1 as a broad rule of thumb, IMO, it might be better to compare PEG ratios of companies with similar prospects. "The term "similar prospects" means companies with approximately equal earnings predictability and growth rate. Jim's comment sounds reasonable to me.I tend to think that a high PEG value is a warning that PE values may become lower in the future. The higher the value of PEG, the greater the probability that the PE value will decrease. Hence the PEG value could influence judgment used to select a high PE in Section 4A of a Stock Selection Guide (SSG).
ftp://better-investing.org/pub/i-club-list-files/ratio-analysis-workshop.txt |
