The PEG ratio is a simple tool that can be useful in your search
for undervalued stocks. But it is far from a perfect metric and is
no substitute for doing your own homework.
Before we examine its shortcomings, let's first explore what it is.
PEG Ratio Defined
The PEG ratio takes the basic price-to-earnings ratio one step
further by factoring in earnings growth. In short, companies with
faster earnings growth warrant higher P/E ratios.
This metric was first popularized by Peter Lynch and is calculated
According to Lynch, a company that's fairly priced will have a P/E
ratio equal to its growth rate. In other words, a stock with a PEG
ratio of 1.0 is fairly valued, while a stock with a PEG ratio of
less than 1.0 is undervalued and a stock with a PEG ratio greater
than 1.0 would be overvalued.
No Magic Bullet
While this seems intriguing and intuitive, remember it is only a
rule of thumb
. The assertion that a P/E ratio should equal earnings growth is
somewhat arbitrary and certainly does not apply to all companies.
Consider a blue chip company operating in a mature industry. Its
earnings growth may only be 5%. Does that mean it should have a P/E
ratio of 5? What if it pays a huge dividend? What about a company
with no growth... or even negative growth?
The intrinsic value of a business is the total of all its free cash
flow available to owners discounted to the present value. This, of
course, can be extremely difficult to calculate with any accuracy.
So the PEG ratio is simply a proxy for it, and nothing more.
There is also no consensus on whether to use a trailing or a
forward P/E ratio and whether to use next year's expected growth
rate or a longer-term expected growth rate. But this can have a
major impact on the PEG ratio calculation.
Beware Those 5-year Growth Rates
I would argue for using a forward P/E since the stock market is
forward looking, along with a longer-term earnings growth rate to
keep a long-term perspective. However, use the long-term earnings
number only with a great deal of caution. That is because the
long-term earnings growth rates that analysts publish are often
way too optimistic
A study by J. Randall Woolridge and Patrick Cusatis of Penn State
showed that analysts consistently project EPS growth rates much
higher than actual growth and that companies rarely meet or exceed
their projected EPS growth rates. In fact, over a period of more
than 20 years, Woolridge and Cusatis found that analysts' long-term
EPS growth forecasts averaged +14.7%, but companies actual
long-term EPS growth averaged only +9.1% - almost 40% lower.
The study also found that analysts almost never forecast negative
long-term EPS growth, although it happens quite frequently.
So do your own homework, and make sure those growth rates seem
reasonable. Because many bad investment decisions have been made
based on off-the-wall earnings growth projections.
3 Deceiving PEG Ratios
So what are some deceptively attractive PEG ratios out there right
now? Here are 3:
PEG Ratio: 0.6
5-Yr Projected EPS Growth: 10.5%
Apollo Group owns several for-profit educational institutions
including the University of Phoenix. A PEG ratio of 0.6 looks very
attractive at first glance. However, if you look a little closer,
enrollment, revenue, profit margins and earnings have all been
moving in one direction for Apollo: down. In fact, based on current
consensus estimates, analysts project a 20% decline in earnings for
Apollo this year and a whopping 38% decline next year. It seems
very unlikely that the company can get to 10.5% average EPS growth
from there in just a couple of years.
PEG Ratio: 0.6
5-Yr Projected EPS Growth: 16.9%
Cirrus Logic develops high-precision analog and digital signal
processing components for consumer entertainment electronics,
including smartphones. A high tech company with a PEG ratio of 0.6
might sound alluring, but based on current consensus estimates,
analysts project a 32% drop in earnings this year and a 30% drop
next year. The company would have to right the ship very quickly to
see anywhere near 16.9% average EPS growth over the next 5 years.
PEG Ratio: 0.4
5-Yr Projected EPS Growth: 20.4%
Vale is a metals and mining company headquartered in Brazil. A PEG
ratio of 0.4 might be tempting, but investors will probably be wise
to ignore its siren call. Based on current consensus estimates,
analysts project a 5% drop in earnings for 2013 and a 12% drop in
2014. And those estimates have been declining for several months.
It's very unlikely that Vale can compound its earnings at an
average of more than 20% from here when earnings are expected to
decline this year and next.
The Bottom Line
The PEG ratio can be a useful rule of thumb for finding undervalued
securities. But it should only be a starting place in that search.
Don't blindly rely on those published 5-year growth rates and do
your own homework!
Todd Bunton is the Growth & Income Stock Strategist for
and Editor of the
Income Plus Investor service
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