Be Cautious When Using the Price Earnings Growth Ratio

Be Cautious When Using the Price Earnings Growth Ratio
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Be Cautious When Using the Price Earnings Growth Ratio

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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.

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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

Hot Hares and Tasty Tortoises are both fast food outlets with a price earnings ratio of 15. This PE ratio is considered interesting by value investors who are examining the two stocks with a view to making investments. Hot Hares is also showing fast earnings growth and is of interest to growth investors. The predicted earnings of the two corporations in the next three years are as follows:

Name                     Current earnings              year 1                    Year 2                    Year 3

Hot Hares                100                                       120                           144                         173

Tasty Tortoises     100                                       105                           110                         116

Hot Hares has predicted earnings growth of around 20% while Tasty Tortoises has earnings growth of around 5%. Although the stock of both corporations has the same price earnings ratio, an application of the PEG ratio shows the effect of earnings growth on that ratio. When the price earnings ratio of 15 is divided by the earnings growth rate the result is as follows:

PEG ratio – Hot Hares                     15/20 = 0.75

PEG ratio – Tasty Tortoises          15/5 = 3.0

As with the price earnings ratio, the lower the PEG ratio the more interesting the stock may be to the investor. A PEG ratio of 0.75 is generally considered very interesting for the investor. The growth investor may already be reaching for the wallet but this is the time for the value investor to pause and think about the two companies in greater detail. Although analysts may be unanimously predicting future growth of 20% in the earnings of Hot Hares there may be problems with this figure. Future earnings are sometimes exaggerated by analysts and by the management of a corporation. Earnings may come under threat from many directions and these threats remain unseen until they suddenly materialize and throw the earnings projections into turmoil.

In the case of Tasty Tortoises, the PEG ratio of 3.0 is normally not considered very attractive. The PEG is however only a rough indicator of stocks that may be attractive to investors and the ratio does not necessarily work so well for stocks of companies with lower rates of earnings growth. The investor should continue to look at other fundamentals before making an investment decision.

Threats to Continued Fast Growth

The reasons for the predicted growth rates must be examined in detail. At the present time future predictions cannot just be based on past performance. The continuance of fast earnings growth must be justified by solid facts. For example the earnings growth may be based on current upward trends in customer numbers, expansion into more outlets and more geographical areas, increased brand recognition, lower costs due to economies of scale, planned overseas investments or improvements in the pricing strategy. The value investor must examine the reasons for the predicted growth in earnings and think of the possible pitfalls that can stand in the way of this growth.

Generally, analysts tend to overestimate future growth of corporate earnings, owing to the difficulty of estimating future performance and the dangers of basing predictions on past performance.  Investors should always be cautious when looking for growth stocks and should never omit to perform an analysis of the fundamentals. The investor should be sure that the stock is still undervalued even if future predictions turn out to be exaggerated. In other words the investor should ensure there is a significant margin of safety before deciding to buy the stock.

Deciding To Step In and Invest

The value investor may decide to invest based on analysis not just of financial ratios but of management competence.  The investor could wait and see if the share prices go down further owing to market sentiment about the companies or the fast food industry. The stocks could then be cheap enough for the value investor to acquire with a sufficient margin of safety despite doubts about whether the intrinsic value of Hot Hares is quite as high as analysts are currently implying.

Market fears about the economic situation may also cause all share prices to fall although the fundamentals of the companies have not changed. Worries about the debt crisis in Europe or other concerns about the world economy could cause falls in stock prices generally and this may be a time for the value investor to step in and buy. The ultimate decision to buy should not be made on the basis of the PE ratio, PEG ratio or any other metric alone. The decision to buy shares must be based on research of the company’s fundamentals using all available information, backed up by an opinion of the competence of the management.


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