Be Cautious When Using the Price Earnings Growth Ratio

The price earnings growth (PEG) ratio is based on simple logic (and invented by legendary investor, Peter Lynch). If the investor is purchasing a share in the future earnings of the corporation, a growing enterprise will have greater profits in the future and will therefore ultimately have more cash to distribute back to the investor. The investor would therefore expect to pay more for a stock that is predicted to grow more in the future. If the price earnings ratios of two stocks are the same, the stock of the enterprise with higher earnings growth is the logical choice for an investor provided that the fundamentals are sound.

It is therefore normal for a higher growth company to have a higher PE ratio than a similar company with lower earnings growth. This higher value for the PE ratio might distract the attention of the value investor from the stock of the company with higher earnings growth, and applying the PEG ratio may help to correct this and draw the investor’s attention to attractive growth stocks. The PEG is therefore a ratio that can permit investors to apply principles from both value and growth investing. It is a way of indicating a growth stock that may be a genuine value stock as well.

This is fine for the value investor as long as the PEG ratio is used as an indicator only. It can be seen as a first signal that must be followed up by further research. The normal principles of value investing must be followed and analysis of management strategy and competence must be carried out in addition to looking at other fundamentals.

Before becoming carried away with enthusiasm for the PEG ratio the investor must remember that a ratio is only as good as the data on which it is based. The investor must look at the basis for the predicted growth rate of the stock. Very high rates of earnings growth are difficult to sustain for any length of time owing to various factors.

Example – Hot Hares and Tasty Tortoises

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