Thursday, September 15, 2011

Price Earning Growth (PEG) Factor

The PEG Factor, is the price-earnings (PE) ratio divided by the earnings per share (EPS) growth rate. The PEG factor measures the relative cost of earnings growth at the previous day's closing share price. The formula is the following:

= PE ratio / EPS Growth Rate

The PEG ratio is a tool that can help investors find undervalued stocks. When used in conjuction with other ratios, and the sector, it provides investors a perspective of how the market views a firm's growth potential in relation to EPS growth.


- A PEG factor equal to one, means that the market is pricing the stock to fully reflect its EPS growth potential.

- A PEG factor greater than one, indicates that either the stock is overvalued, or that the market expects its future EPS growth to be greater than the current consensus.

- A PEG factor less than one, indicates that either the stock is undervalued, or that the market does not expect the company to achieve its forcasted EPS growth.

The PEG Ratio is a simple but useful tool for comparing the value of stocks.
The PEG stands for Price, Earnings, Growth. The ratio is calucated as follows:
  • Price (the latest stock price) / Earnings (expressed as Earnings per Share) / Growth Rate (% earnings growth p.a.)

Another way to remember the formula is: PEG Ratio = (PE Ratio) / (Growth Rate).

PEG Ratio vs. the P/E Ratio

The PE Ratio is probably the most often quoted financial ratio. It is certainly not without merit. That one number quickly tells us how much a company costs relative (price) to how much money it makes (earnings). Using the PE Ratio we can easily compare stocks with other investment opportunities.

For example:

Imagine you have $500 to invest.
Stock in a well known, stable company costs $50 per share, and makes $5 per share in profit per year. The company has a PE Ratio of 10.

A local bank is offering %5 p.a. interest on a savings account. Putting $500 in the bank would make you $25. The savings account has a PE ratio of 20.
Putting your money in the bank, your investment would grow from $500 to $525.
Investing in the company, your investment would grow from $500 to $550. Twice the increase.
For now, the company appears to be the far better investment...

Going back to our three companies with their respective PE Ratios and PEG Ratios. If we compare them in the same way as we did above, using the PE Ratio, ABC company provides the best return on investment with a low P/E of 5.

Company ABC is growing its earnings at the slowest rate. Over the longer term, the other companies will increase their earnings and their PE Ratios will contract, possibly making them the more better investement overall.

This is where the PEG Ratio comes in, it takes the PE Ratio and adjusts it for growth in future earnings. According to the PEG Ratio, XYZ company is the best value investment. Despite being measured as more expensive by the PE Ratio, it has twice the growth rate and will likely have a better return on investment over the longer term.

Looking at LMNO company, it is 4 times as expensive as ABC on a Price to Earnings basis but is valued equally with it by the PEG Ratio. Not coincidentally, LMNO company is growing its earnings 4 times as fast as ABC.

Stocks with high earnings yields (Low PE Ratios) such as ABC are often referred to as Value Stocks. Stocks which have a high rate of earnings growth (and usually a low earnings yield) such as LMNO company are known as growth companies.

Despite the dramatically different earnings and growth profiles of ABC and LMNO, they both have a PEG Ratio of 1.66. This is a good demonstration of how the PEG Ratio is effective at comparing both growth and value in stocks. This is where the PE Ratio falls down.

What are the drawbacks of using the PEG Ratio?

So after comparing how the PE Ratio and the PEG Ratio work, why would we ever use the PE Ratio instead of the PEG Ratio?

Basically, a value company with high present earnings and low growth (i.e. good on a PE Ratio basis, mediocre on a PEG Ratio basis) has at least proven it is making money now. A company with a high growth rate but a low earnings yield (i.e. poor on a PE Ratio basis, better on a PEG Ratio basis) is relying on future earnings to justify its worth. Future earnings are based on estimates and projections drawn from assumptions about future business conditions and economic factors.

The growth rate is nothing more than an educated guess, while current earnings are known and real.
Stemming from this is the question of which growth rate to use?
Longer term growth rates are more important but less reliable while near term growth rates matter less but are more accurate...

However, the same argument about future unknowns also supports the use of the PEG Ratio. While a company's most recent earnings are bankable, that does not guarantee that they will increase or even remain at the same level. Quite often when a company has an incredibly low PE Ratio, it is because earnings are projected to contract in future. The PEG Ratio includes this information in making comparisons.

Technical problems with both PE and PEG Ratios

When calculating either ratio, the comparisons no longer make sense if a company is making losses. A company with a PE of -2 is making a loss of half of the company's stock price every year. A company with a PE of -100 is only losing 1% of it's worth even though -100 sounds a lot worse than -2.

A similar issue is encountered with the PEG Ratio and negative growth rates. The calculation produces very strange results when using negative growth rates and negaative earnings. What does the growth rate of negative earnings even mean?

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