Hi mindmeld & GV and thread - people don't seem to understand PE, PEG or FCF...
For the rest of the thread who might not know about PE ratios, here's some fundamental stuff to ponder.
PE is a simplified form of Discounted Free Cash Flow that depends on a lot of assumptions. PEG is garbage. Here's why.
True economic value "V" of the firm is the finite sum of free cash flow "C" discounted to present value.
We assume we have visibility for some number of years t. Then we can calculate V = {SUM [Cn / (1+r)^n]} + R. Cn is free cash flow in year n. r is the discount rate, and "R" is residual after t years, generally given by R = [a x Ct / (1+r)^t] where we assume "a" is a constant based on future "steady state" behavior, and Ct is cash flow in terminal year t.
If we assume the business scales cash flow proportionate to earnings, then Cn = K x En. We re-write V = K x {SUM [En / (1+r)^n]} + R.
If we assume a constant rate of growth, then Cn and En are related to each other by this constant rate. So we get
V = K x E0 x { SUM (1+e)^n/(1+r)^n } + R - where E0 is earnings in year zero, and e is rate of earnings growth. A bit of algebra shows R is also proportional to E0.
A little more algebra allows you to write V = E0 * [ (K x A ) + B ] where A (that sum of exponentials) and B (residiual value divided by E0) are simply numbers that depend only on the choice of K, e, r, t and a.
In other words V = E0 * F(K,e,r,t,a)
Rewrite, you get F(K,e,r,t,a) = V/E0
If you assume you pay a price proportionate to value, and E0 is earnings in year 0... well golly gee whiz... F(K,e,r,t,a) would be the PE ratio!!!
It isn't hard to see that the same company would deserve different PE ratios depending on assumed relationship of cash to earnings, rate of earnings growth, risk free rate of return, forward visibility and terminal value.
This is why PE is great for static companies with predictable rates of growth and business metrics. For growth companies in which all of these ratios change... the fundamental basis for using PE goes out the window.
Finally, you will also note that PE*e [the basis of PEG] is a number without relationship to value... Go back through the equations above and try to figure out why.
So why PEG should bear relationship to price is more coincidence than fundamental analysis. IMHO.
Nevertheless, those who use PE or its more dubious cousin PEG for a growth stock like CSCO... well, let the buyer beware.
The rumination of wise bulls about CSCO PE back a year ago should stand as a warning to those who would keep it up this year.
John. |
