Financial metrics such as P/E ratios, price to cash flow ratios, PEG ratios, price to sales ratios, price to book value, and many others, should be thought of as tools in the investor’s toolbox. They can all be useful when appropriately utilized towards putting together a successful stock portfolio. However, just as you wouldn’t be able to build a house with only a hammer or a saw, this same logic applies to building a portfolio. Any task is made easier when you have the proper tools at your disposal and when you use them appropriately. You wouldn’t try to pound a nail with a saw or try to beat a board in half with a hammer. You would use the hammer for the nail and a saw to cut the board.
PEG Ratio: Definitions
Proponents of the PEG ratio allege that it is superior to the P/E ratio as a valuation metric because the P/E ratio does not take the company’s earnings growth into consideration. To an extent, I tend to agree with that assertion. On the other hand, I personally never utilize the P/E ratio without simultaneously considering a company’s earnings growth past, present and future potential. But most importantly, not all proponents of the PEG ratio define it exactly alike. Here are several definitions that illustrate my point:
Courtesy of INVESTOPEDIA here is one definition of the price/earnings to growth ratio or PEG ratio:
[drizzle]“What is the 'Price/Earnings To Growth - PEG Ratio'
The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio.
According to this definition a lower ratio indicates a cheaper stock and a higher ratio indicates a more expensive stock. The equilibrium PEG ratio would be one where earnings growth and the current P/E ratio are equal.”
Although this is a reasonable definition of the PEG ratio, I find it somewhat vague regarding the specified time period. Are they talking about past earnings growth or future earnings growth? And if they are talking about future earnings growth, what timeframe are they utilizing?
Wikipedia offers a similar but perhaps slightly more precise definition because it specifies expected earnings growth over historical growth. Nevertheless, this definition still does not speak directly to how far into the future forecasting growth should be calculated.
“The PEG ratio (price-earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth.
In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies appear overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.”
The website Nasdaq provides a definition that is slightly more specific alleging that the PEG ratio is based on consensus estimates for earnings over the next 12 months as follows:
The PEG ratio is the Price Earnings ratio divided by the growth rate. The forecasted growth rate (based on the consensus of professional analysts) and the forecasted earnings over the next 12 months are used to calculate the PEG.”
The blog “Inside Investing” produced by the CFA Institute produced an interesting read on August 16, 2012 titled “Is It Overvalued? Look at the PEG Ratio. Here is a link to the full blog and a short excerpt with a second link that is appropriate to this series of articles:
“We discussed the P/E and why it is a good measure of the relative valuation of two companies in a previous post here. One of the major drawbacks of this valuation measure, however, is the static nature of the analysis it provides. If you’re thinking that sounds a bit wonky, you’re right, it does. OK, it sounds really wonky! Geez.
What I mean by “static nature” is that the P/E really just looks at valuation at one point in time, like a snapshot of the two companies at that moment. One of the things that comparing the P/Es of two companies fails to take into account is the respective growth rates of each of the companies—in other words, how much each company will earn next year compared with what it earned this year.”
What I’m suggesting by sharing these various definitions is that the PEG ratio is not universally calculated. Consequently, when you are seeing the PEG ratio reported on various financial websites, it’s important to know precisely what timeframe is used to estimate the earnings growth rate. Sometimes it will be 1 year forward, sometimes it will be 5 years forward (this timeframe might be the most common) and sometimes historical earnings growth will be utilized. Therefore, I caution the reader that utilizes the PEG ratio to be sure they understand what earnings growth rate is being utilized.
The Origin of the PEG Ratio
The origin of the PEG ratio was originally attributed to the author Mario Farina who wrote about it in his 1969 book, “A Beginner’s Guide To Successful Investing In The Stock Market.” However, the popularity of the PEG ratio is primarily credited to Peter Lynch based on his 1989 best-selling book “One Up On Wall Street.” However, Peter Lynch did not specifically talk about the PEG ratio as it is widely used today. On the other hand, he did essentially describe and establish a ratio based on P/Es and growth rates. Here are a few excerpts of what Peter actually said on pages 198 and 199:
“The P/E ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here.”
Then a few paragraphs down he introduced the concept and described it as a ratio of sorts as follows:
“In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds.”
However, and here is the interesting part. Most practitioners and devotees of the PEG ratio today base their calculation on an estimate of a company’s future 5-year earnings growth rate. But, Peter Lynch was not recommending that the ratio be based on forward earnings growth. Instead, he suggested utilizing historical earnings growth. Here are his exact words from the next paragraph in the book:
“If your broker can’t give you a company’s growth rate, you can figure it out for yourself by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next. That way, you’ll end up with another measure of whether a stock is or is not too pricey. As to the all-important future growth rate, your guess is as good as mine.”
As I will discuss in more detail later, the PEG ratio is most