It isn't accurate for high- dividend stocks
Simply put, a high dividend can make a company's earnings growth seem slower than it actually is. Instead of reinvesting all of its profits in the business in order to grow earnings, it distributes a chunk of those earnings to shareholders. So this must be accounted for in order to accurately value a company while taking its earnings growth into account.
Adjusting the ratio for dividends
In order to calculate a dividend-adjusted PEG ratio, we need to add the stock's dividend yield to its expected annual growth in the denominator of the PEG ratio formula listed above. Mathematically, our formula now looks like this:
Using our previous example of Apple, let's calculate its PEG ratio and its dividend-adjusted PEG ratio in order to illustrate the difference this makes.
An example
First, Apple's stock trades for just under $100 as of this writing, and the company earned $8.99 over the last 12 months. Thus our P/E ratio is 11.1. According to S&P Capital IQ, Apple's estimated earnings growth rate over the next three years is 9%. This implies that Apple's PEG ratio is 1.23.
However, Apple pays a dividend yield of 2.3%. Adding this to the 9% projected earnings growth gives a total of 11.3%. Our dividend-adjusted PEG ratio formula reveals a new ratio of 0.98. In other words, Apple is significantly cheaper than its PEG ratio makes it appear.
So the next time you're sizing up different dividend-paying investments, be sure to use the dividend adjusted PEG ratio to help you pin down their true value.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
