Mike:
As I fell asleep last night something you wrote here hit me, and leads me to believe that there was something else I did not express clearly:
for the very reason you mentioned -- that growth doesn't come in a linear fashion.
Actually what I was trying to express (original below) was not about whether growth is linear or not. Even a slow grower will not have linear growth - growth will be compounded. Of course everybody's growth will not follow a perfect curve. But that is not what I was writing about.
What I was writing about was the problems with the rule of P/E should approximate the growth rate. A zero grower is not worth a P/E of zero, but is worth far more. When I wrote that "The faster an asset increases its asset flows, the more it deviates to a value well above where its PEG suggests it." I was pointing out that the higher the growth rate, the higher the P/E can be relative to the growth rate. e.g., a growth rate of 30% might support a P/E of 40, but a growth rate of 50% might support a growth rate of 75 (all numbers made up, don't take them seriously). Now of course many recognize this, but then they struggle with what P/E (or PEG) is acceptable for a given growth rate. That relationship can be worked out and tabulated, as I mention in the last paragraph below.
- Pirah
The big reason that PEGs tend to undervalue such companies is because of a problem inherent to PEGs. PEGs assume a linearity that does not exist. An asset which puts out a constant, not growing, stream of free cash flows is not equal to zero. The faster an asset increases its asset flows, the more it deviates to a value well above where its PEG suggests it.
Even B. Graham recognized this - his formula for the value of a company based on its earnings started with "8.5+..." - though even that is only good, as Graham acknowledges, for growth rates which are modest.
There is no need for us to use the linear relationship, or even to come up with discreet rules of thumb. If one understands the underlying principles one can come up with a chart which gives the appropriate PE ratio for any given growth rate. Which will work much better for emerging or strong gorillas. |
