Londo here is an article(from earlier this year) that ends up basically saying the only way you can get to company's true status is in depth micro-anaysis---hard work--grr:)(i want short easy answers--max)
BURY THE PEG RATIO
by Jeffrey Bronchick 07:00 AM 04|04|2001
It's a fallacy-ridden theory that will cause your portfolio to self-destruct.
Who out there isn't tired of reading "is-this-the-bottom" articles? Apparently, you either have to trek to Nepal to avoid the claptrap completely, or simply ignore it and skip right to the sports page. Bottom-finding exercises for the market as a whole are of little value -- none if you are investing on a security-by-security basis. In that case, the only bottom you're interested in is the one immediately below what you own!
Nonetheless, I am drawn like a fat moth (figuratively speaking) to a porch light on a summer night (wishful March thinking) to articles that use the so-called PEG ratio to try to justify why the stock market, or some part of it, is at the bottom and now an attractive investment. I suggest, for reasons laid out below, that your portfolio will eventually self-destruct if you adopt the PEG as the main driver of your decision-making process.
The PEG is simply the price-earnings ratio divided by the estimated growth rate of per-share earnings. A distressingly large number of investment professionals are torturing the heuristic assumption that, all else being equal, the desired PEG ratio is 1-to-1 -- that is, a P/E equal to the growth rate. Twisting this rule of thumb in a relative way, they say something to the effect that "the sector is cheap because the PEG ratio of 1.6 is down substantially from 2.3 reached at the end of 2000." There are so many things wrong with this line of reasoning that it may be difficult to make the counterargument in the allotted space, but I'll give it a shot.
Before discussing the fallacies in the theory behind PEG, let's look at the components that make the holes in the theory more obvious -- i.e., price, earnings per share and the earnings growth projection. We can all agree on price, of course. It's the other two variables that throw a wrench into the works.
Take earnings per share, instance. What constitutes EPS is a topic that is attracting well-deserved negative publicity now that its usefulness as a scorecard of corporate achievement is plumbing new depths. The list of distortions fostered by undue attention to EPS is, as noted before in this space, a long one. They include acquisition-accounting differences; the ability under GAAP to capitalize and write off capital spending vs. the immediate expensing of R&D-related spending; varying revenue-recognition, depreciation and stock-option accounting policies; balance sheets contorted to produce desired numbers in the short run, and so on. As we have seen, where there's a will, there's a way. Thus, ever more excruciating financial gymnastics are employed to meet unholy expectations and thus preserve, if only temporarily, the appearance that all is well on the earnings line.
Common sense -- if not the garbage-in, garbage-out theory -- should therefore dictate that the price-earnings ratio can be misleading when used as the sole indicator of value. One might also note that in more cyclical businesses, all else being equal, the higher the P/E, the better -- the implication being that earnings are at a trough and the next move will be a sharp one to the upside. And what about businesses that are "build-it-and-they-will-come" endeavors, like cable, cellular and satellite broadcasting, among others? If P/E is your sole guiding light, you will miss out on those. More specifically, despite P/E's surface appeal to a value investor, a number of academic studies have consistently shown a low correlation to subsequent stock price, mostly because, as detailed above, earnings can be manipulated.
An approximation of growth in earnings per share, then, is fodder for more folly. To be sure, any estimation of intrinsic value does require some estimate of growth. But the annoying thing about the future is that it is almost always uncertain, so betting a large grubstake on aggressive growth numbers is fraught with complications. Not to mention that most "consensus" growth estimates, as many are belatedly discovering, are way too high. But, then, there is a self-evident bias: Sell-side analysts, 95% of whose recommendations are "buys" or "holds," are trying to sell a story, and a higher growth rate always makes the story better. Corporate management often operates with a similar behavioral bias in the sincere belief (which it will repeat to anyone who asks) that it can always grow its own business faster than the industry, thus making it immune to the problems besetting everyone else.
Eighteen years in the investment business have given me to realize that the default EPS growth rate, as intoned by management and analysts, is "12% to 15%." For perspective, the S&P 500's average annualized growth rate is something closer to 7% for extended periods of time. An interesting day of reckoning is fast approaching for the new paradigm that says the growth rate has risen on a secular basis thanks to the twin miracles of technology and productivity enhancement.
I have no particular reason to pick on Morgan Stanley Dean Witter, but a recent strategy piece by Peter Canelo illustrates many of the deficiencies I'm talking about. I have reprinted his PEG chart below. It is a bottom-up look at what analysts expect for EPS growth going forward, and, needless to say, it looks grossly overoptimistic. To be fair, Canelo uses a number of arguments to support his case that the market is undervalued, but the PEG argument is clearly his stool's wobbly leg.
Moving away from PEG component flaws, the big-picture flaw is twofold. The first is that it ignores interest rates. Evaluating the appropriateness of a P/E -- assuming it were a relevant benchmark -- is impossible without an interest-rate factor. In a 4.5% interest-rate environment, a 20 P/E may be borderline reasonable, whereas the same company can be grossly overvalued at a 15 P/E in an 8.5% interest-rate environment. A relevant judgment on P/E simply can't be made without an interest-rate factor. An intrinsic P/E can be calculated by working mathematically from a basic discounted cash-flow model. You divide the target price by the base EPS used to start the series and create a model P/E, but the key number is still the interest rate.
Think of it this way: If a company is expected to generate $1.50 per share in real earnings, but has to reinvest 50 cents back into the business every year to stay alive and has zero growth, with a 10% cost of capital it should still be awarded a P/E of roughly seven based upon simple discounted cash flow. With an 8% cost of capital, the same company has a fair-value P/E of 12.5. Yet the PEG says it's worth . . . zero?
The second big-picture issue is that all growth is not equal. In fact, it is painfully easy to generate EPS growth that conceptually should be rewarded a large PEG number, but that actually destroys shareholder value. That's because the other variable missing in PEG is return on capital. In the example above, a company could borrow money at a 12% rate, invest in a plant that returns 10% and, voila, produce EPS growth. Is it worth more than the stuck-in-the-mud company? PEG says yes, but reality says no. Growing EPS via expansion that returns less than the cost of capital eats value. This grossly misunderstood concept has caused shareholders an enormous amount of pain, but it is overlooked by PEG analysis.
So, having said that the PEG ratio is misleading at best, that macro-guesstimates are nearly useless, and that an investor's time is much better spent on micro company analysis, I toss out the following model. It shows that, subject to some gross overgeneralizations -- like a flat earnings year in 2001, followed by an orderly 8.5% growth rate until hell freezes over in the 11th year, at which point the world economy becomes a flat-line, cash-generating perpetuity -- the "market," as defined by the S&P 500, is within 11% of a bottom. Is the model accurate? Your guess is as good as mine.
Jeffrey Bronchick's "From the Buy Side" column appears regularly in Grant's Investor. Mr. Bronchick is chief investment officer of Reed, Conner & Birdwell and manages the RCB Small Cap Fund. Any positions Mr. Bronchick or RCB holds in any securities he writes about will be disclosed in the column. Under no circumstances does the information contained in this column represent a recommendation to buy or sell any security or securities. The material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such.
>> end quote,from www.grantsinvestor.com |
