Tom and all- Qualcomm valuation and the PEG- Sometime back I emailed Mr. Gerstein (Director of Investment Research, Multex) regarding another article he authored asking if he had done any or new of any research on historical PEG ratios of the S&P500. He replied negatively, but I found this article on the Market Guide (Multex) site today. I’ve been using the PEG ratio in my valuation analysis of Qualcomm and have been challenged by most as to its value. BTY, Qualcomm’s PEG is 1.44- ($36.80/ 1.24 EPS FY03 = 2.9 PE / 20.5 LT Growth rate %). The EPS and Growth rates are “analysts” consensus estimates. FWIW, as I’ve expressed a few times before, I believe Qualcomm’s 3-5 year growth rate is much greater that 20%. In normal markets with a LT interest rate at 5% (4.91 as of Friday) a stock with a long term growth rate of 20% should command a PE of 42.7 (2.1 PEG) according to an old SSB study I’ve hung onto. I usually use a 1.8 PEG in my analysis. Most articles I’ve read state that the PEG should be 1 or less when properly valuing a stock. When I’ve challenged the authors for their documentation, I’ve received no replies. These statements in the attached article I found the most interesting-
1. It is very widely believed that a stock's P/E ratio should be equal to or less than the company's EPS growth rate. Stated another way, the PEG (P/E divided by growth) ratio should be equal to or less than 1.00.
2. In recent years, investors have been burned by a variety of analytic and/or valuation errors. But the 1.00 PEG ratio is a different sort of thing. This kind of error can actually help us. I gave only one example in the discussion above. But in experimenting with other real-life cases, I cannot help but notice that often, theoretically correct PEG ratios wind up well above 1.00, a situation that's likely to hold true absent a very dramatic rise in interest rates (more of a rise than we're likely to see any time soon).
3. That means if you can find shares of good companies with PEG ratios at or below 1.00, you're looking at some serious value.
marketguide.com
PEG: fact or fairy tale? 2003-01-15
Sometimes, an investment idea that's more folklore than fact can still be of help to you.
by Marc Gerstein, director of investment research
The folklore
It is very widely believed that a stock's P/E ratio should be equal to or less than the company's EPS growth rate. Stated another way, the PEG (P/E divided by growth) ratio should be equal to or less than 1.00.
Have you ever wondered where this notion comes from?
Suppose a stock has a P/E of 18 and a growth rate of 20 percent. What's the PEG ratio? One might assume it's 0.90, which is what we'd get if we divide 18 by 20. But that is not mathematically correct. We aren't REALLY dividing 18 by 20. The growth rate is a percent, not a "whole number." Strictly speaking, we should be dividing 18 by 0.20, which works out to 90.
Picky, picky, picky!
What's the big deal about an unstated assumption that we multiply the growth rates, expressed as percents, by 100 before computing the PEG ratio. It's just a cosmetic thing. It's a lot more convenient than saying a PEG ratio should be equal to or less than 100 times the growth rate.
But is it really just a matter of linguistic convenience? Or is the lack of mathematical rigor in the conventional definition symptomatic of a deeper flaw?
The reality
Let's start with the single most basic mathematical formula for calculating the price at which a stock should sell.
P = D/(R - G)
Where
P = the stock price
D = the dividend
R = the required rate of return
G = the growth rate
Don't worry about the details right now. If you want to follow up on this issue, you can click on the Education link on the left-hand menu. There, you'll see a series of articles addressing the basics of stock valuation. And there will much more discussion of valuation principles in the year ahead on this site and in my second book, The Value Connection, which is scheduled for release in July 2003.
What we really want to do is use the above equation, known as the Gordon Dividend Discount Model, to help us understand P/E.
First, for dividend, we'll substitute a mathematical equivalent: EPS multiplied by the payout ratio. For cosmetic purposes, I'll refer to EPS as just "E."
P = (E * Payout)/(R-G)
One of the supposedly fun things about algebra is the many ways we can re-shuffle equations. If we divide both sides of this one by E, it looks like this.
P/E = Payout/(R-G)
Voila! That is a theoretical model you can use to calculate a "correct" P/E ratio.
You'll notice that "G," growth, is one factor. You'll also notice that the higher the growth rate, the higher the P/E. (As the value of G rises, the lower part of the fraction, the denominator, shrinks. And as the denominator shrinks, the overall expression, P/E, gets bigger. That's a familiar scenario; as growth goes up, so too does the P/E.
Most important, notice that G is not the only relevant factor. The payout ratio is very vital. Mathematically speaking, the most important part of E is the part that passes into the shareholders' hands, which is E multiplied by the payout ratio. (The R-G part of the expression deals with the notion of reinvestment of profits in anticipation of a bigger payday in the future.)
R also has a big impact on P/E. R is heavily influenced by prevailing interest rates. As rates go up, the denominator gets bigger causing the overall expression, the P/E to get smaller.
Trying this at home
Be careful about trying to use this formula on your own to make real-life investment decisions. There are very serious practical limitations. You need a lot of modification in order to deal with companies that don't pay dividends. You also need a lot of modification to cope with situations where G is greater than R. These issues are discussed in the Education-section articles referred to above.
But I'm sure few could resist taking at least one peek at a situation for which the equation might actually work. Let's consider Procter & Gamble. I'm going to use a 10 percent assumption regarding required annual return, the company's 7.57 percent five-year dividend growth rate, and its current 46.48 percent payout ratio.
Applying the formula, I get a P/E of 18.05. Using conventional PEG ratio calculations (i.e. multiplying the growth rate by 100 so we're not mixing whole numbers and percents), the theoretically correct PEG is 2.39 if I use the historic dividend growth rate, 2.86 if I use the historic 6.31 percent annual EPS growth rate, or 1.63 if I use the 11.08 consensus projected long-term EPS growth rate.
We can debate which growth rate should be used. But however that's resolved, the theoretically correct PEG ratio is not likely to come anywhere near 1.00.
But I could get a 1.00 PEG ratio if I were to pretend that PG shift to a payout ratio of 18.5 percent (through a lower dividend or higher profits). That makes sense. If the company is distributing less earnings to shareholders, they should be willing to pay a lesser multiple of earnings in order to own the shares, unless the company can use the its retained earnings to boost growth. If I push the dividend growth rate up to 9 percent per year, we can get a 1.00 PEG with a payout ratio of 9 percent.
Is your head spinning? If so, it means you've grasped the notion that there's a lot more to the notion of a correct P/E than a simplistic comparisons with growth rates.
The good news
As of this writing, PG's real-world PEG ratio is hovering around 2.00 (it's a bit more or a bit less depending on whether you want to compute P/E using the consensus estimate of current year EPS or the estimate of next year's results). Based on what we saw above, we'd seem to be on solid ground if we describe PG shares as being reasonably valued (assuming, of course, that we believe the growth projection, a major issue when analyzing individual stocks).
Suppose the stock was priced much lower and had a PEG ratio around 0.90. That's lower than it needs to be. We don't necessarily have to argue over whether the correct PEG is 1.00 or something close to 2.00, because either way, PG stock would be a steal.
In recent years, investors have been burned by a variety of analytic and/or valuation errors. But the 1.00 PEG ratio is a different sort of thing. This kind of error can actually help us. I gave only one example in the discussion above. But in experimenting with other real-life cases, I cannot help but notice that often, theoretically correct PEG ratios wind up well above 1.00, a situation that's likely to hold true absent a very dramatic rise in interest rates (more of a rise than we're likely to see any time soon).
That means if you can find shares of good companies with PEG ratios at or below 1.00, you're looking at some serious value.
Our Growth At A Reasonable Price screen
The Multex Investor Growth At A Reasonable Price (GARP) screen uses the 1.00 PEG threshold. It uses a forward-looking PEG (a P/E based upon estimated future EPS divided by a predicted growth rate) as well as a historic PEG (a P/E based on the trailing 12 month EPS and a historic three-year EPS growth rate).
That's a good starting point. But any value-oriented screen needs to go further. This one includes company-quality tests (to ferret out stocks that are cheap because the companies are dogs), and a share-price momentum test (to identify situations where undervaluation is more likely to be corrected sooner than later). Click here for a more detailed explanation.
The perfromance record of the screen shows that fairy tales can, indeed, come true. Despite being based on a PEG requirement that owes more to folklore than logic, this screen performed quite admirably since we started tracking it on 1/28/00 (with an assumption of equal weightings and once-per-month portfolio re-balancing). From 1/28/00 through 1/10/03, the GARP screen rose 41.39 percent. Over that same period, the S&P 500 fell about 30 percent.
Ticker Company Industry
BPRX
Bradley Pharmaceuticals, Biotechnology & Drugs
CBK
Christopher & Banks Corp. Retail (Apparel)
HOTT
Hot Topic, Inc. Retail (Specialty)
IFIN
Investors Financial Servi S&Ls/Savings Banks
PENN
Penn National Gaming, Inc Casinos & Gaming
PIO
Pioneer Corporation (ADR) Audio & Video Equipment
SLNK
SpectraLink Corp. Communications Equipment
SSNC
SS&C Technologies, Inc. Software & Programming
Marc Gerstein joined Market Guide in February 1999 as Director of Investment Research. Market Guide is a product of Multex.com, a global provider of investment information and technology solutions to the financial services industry. He started working as an equity analyst in 1980 and covered stocks spanning a wide variety of groups including Household Products, Retail, Restaurant, Hotel/Gaming, Media, Natural Resources, Homebuilding, Conglomerates, and Transportation. He also managed a high-yield bond mutual fund and conducted seminars teaching investors how to select stocks using screening software.
The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Multex.com, Inc. does not: (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation. |
