Understanding The Language Of Value - What Do EPS and PEG Ratio Mean?

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When I first walked into a foreign exchange dealing room all those years ago, the first thing that struck me was how hard it all was to understand. It was as if the people screaming at each other were speaking a different language. I later found out that they were. Sure, the basis was English, but the combination of slang and jargon made it incomprehensible to the outsider. Once I became an insider, I too adopted the language, but after a while I came to a conclusion. I later decided that the exclusion of outsiders wasn’t just the effect of all of the jargon... it was the purpose of it.

What I realized was that what we did, buying low and selling high, was fundamentally very simple. If it wasn’t for the baffling language and aggressive attitude that characterized the dealing room any casual observer would quickly see how simple it all was and, more worryingly, that anybody could do the job. The prestige, and more importantly the ridiculously high salary that a dealing room job afforded, would quickly disappear.

I often feel that those that write about markets fall into the same trap. The less understood the metric that they use and the more obscure the acronym, the more impressive they believe they look. In fact, quite the opposite is true. Most people who actually read what we write are smart people looking to be informed. This isn’t just confined to the internet either. Research reports from Wall Street analysts are, if anything, worse. The concentration on one industry usually leads to them adopting not only Wall Street’s jargon, but also that of the businesses they cover. What else explains the fact that energy sector reports, for example, usually talk of oil and gas being “de-risked” rather than simply extracted?

It is not just specific industries that suffer though. When we as writers discuss the relative value of stocks we also fall into the trap. We toss around phrases like PEG ratio and EV/EBITDA as if any fool should know what they are, how they are derived, and why they are significant. In reality, of course, very few people do. I try to use only two valuation metrics in my writing, P/E and PEG ratio. That doesn’t mean that I don’t consider others, of course I do, but I seldom write about them.

EPS: The most basic building block of value calculations, EPS stands for Earnings Per Share. In principle it is simple. It is the total profit (earnings) of the company divided by the number of shares out there, to indicate the amount of profit attributable to each one share. There is, however, a catch.

There are two types of EPS, trailing and forward. The difference comes from what earnings numbers are used. Trailing EPS uses the last 4 reported quarters, while forward EPS uses the consensus of analysts’ estimates for the next 4. Obviously, historical fact is more reliable than an aggregate of educated guesses, but picking stocks is more about what will happen than what did. I tend to look at the range of the estimates and attach weight to forward EPS accordingly. If estimates vary wildly, then it is reasonable to assume that any number based off of an average is less reliable than when there is general agreement. Ultimately, though, it is a case of picking your poison.

PEG Ratio: The problem with EPS, particularly of the trailing variety, is that it doesn’t take into account one of the most important factors in a company’s valuation... growth. The PEG ratio is simply the P/E ratio (forward or trailing) divided by the earnings growth rate of the company expressed as a percentage. Again, what time period, past or future, is used is important.

The most common calculation and the one that I generally use, utilizes the actual earnings for the previous twelve months (trailing P/E) and analyst estimates for the next five years of revenue growth. This may look like mixing two different things, but it makes sense. Historical numbers are more reliable, but in ever changing conditions, past growth tells us nothing.

The PEG ratio enables us to compare value between industries where growth rates can be expected to be very different. In general a lower PEG ratio is desirable, and a number under 1.0 would indicate that a company is undervalued. This is best understood by a simple example. If company XYZ is trading at 20x last year’s earnings and analysts are forecasting revenue to grow by 20% a year on average over the next five years, the the PEG Ratio is 20/20, or 1.0. If the stock is trading at only 10x earnings, however, then the PEG would be 10/20, or 0.5. Similarly if the P/E is 20 but revenues are forecast to grow by only 10% a year then the calculation 20/10 gives us a PEG Ratio of 2.0.

As I said, 1.0 is usually considered the threshold, but in times like these, when value is scarce, the PEG ratio can be used for purely comparative purposes. For example, which is better value; boring, staid old Microsoft (MSFT) or young, dynamic Facebook (FB)? If you look just at P/E then it is MSFT, with P/E ratios of 15.64 (trailing) and 14.53 (forward) versus FB’s sky high 81.89 and 34.74. Factor in growth, however, and the picture is somewhat different. MSFT has a PEG of 2.28, while FB’s is 1.3, making FB the better value pick. Nothing is ever simple and the dividend yield from MSFT would complicate the issue somewhat, but these two well known names demonstrate the principle.

I will, from here on out, make a more determined effort to couch my analysis in language that most can understand. If I do slip into jargon, then it is safe to assume that it is down to my temporary need for approval or desire to impress more than anything. Hopefully, if you have read this piece, then even my insecurity is showing you will understand what I, at least, mean when I say that something represents value.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Basics , Stocks , US Markets

Referenced Stocks: MSFT , FB

Martin Tillier


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