Be careful with screens
This is why screening for stocks by PEG ratio isn’t all that useful. You often don’t know which P/E ratio the screen is using or what growth assumptions it’s using. Even if you did, as we saw above, the uncertainty in the growth assumption makes for even more uncertainty in the PEG ratio.
Using the Finviz stock screener I’ve searched for stocks with PEG ratios below 1 and sorted by market cap. Here are three examples of what I’m talking about.
Apple (NASDAQ:AAPL) – Finviz has Apple’s PEG ratio at 0.53. This would suggest that Apple is extremely undervalued. Looking at Yahoo Finance the range of earnings estimates for the fiscal year ending September 2013 is $40.73 – $51.06. This represents EPS growth between -7.75% and 15.65% and a forward P/E ratio between 8.44 and 10.58 (I’ll ignore the giant cash balance for simplicity). Our forward PEG ratio, then, is anywhere between 0.53 and infinity. Finviz is assuming the highest estimate in its calculation, but the uncertainty here is enormous. The PEG ratio, in this case, is pretty much meaningless.
Intel Corporation (NASDAQ:INTC) – Finviz lists Intel’s PEG ratio at 0.83, also well within the supposed undervalued regime. Yahoo Finance has the range of earnings estimates for fiscal 2013 at $1.58 – $2.17 per share, representing growth from -25.8% to 1.9%. Using 2014 estimates this range is from -20.7% to 17.4%. I won’t even bother going further: it should be clear from the last example that a PEG ratio based on these numbers is completely meaningless. With a current P/E ratio of just about 10, a PEG ratio below 1 would require average annual earnings growth of about 10%. So instead of dealing with analyst estimates, a good question to ask is if Intel Corporation (NASDAQ:INTC) can grow earnings by 10% annually in the long term. Given its market-leading position this seems plausible. This would mean doubling earnings every 7.25 years, conceivable if Intel Corporation (NASDAQ:INTC) succeeds in the mobile market.
Caterpillar (NYSE:CAT) – Finviz lists Caterpillar’s PEG ratio at 0.78. Yahoo finance has the range of earnings estimates for fiscal 2013 a $7.26 – $8.54, both below 2012’s results. The range for 2014 is $8.50 – $10.63, or growth between -4.5% and 19.4%. Again, there’s so much uncertainty here that basing a calculation off of these numbers is pointless. With a current P/E ratio of about 11 the company would need long-term 11% earnings growth for a PEG ratio below 1. Finviz’s number would suggest 14% annual growth, which is the average 5-year estimate from analysts. But as we’ve seen, the range on this estimate is probably enormous, making the uncertainty in the PEG ratio even more enormous. Just because it’s an average doesn’t make it more correct. Averaging a bunch of terrible guesses does not necessarily lead to a better one.
The bottom line
Whenever you calculate something like a PEG ratio, remember that analyst estimates for growth are rarely correct. The range from different estimates is typically large, leading to an even bigger range in possible PEG ratios. What’s more, using the forward P/E ratio in your calculation compounds the uncertainty and makes the result even worse. The PEG ratio is a rough rule of thumb, and it is very much a garbage-in garbage-out type of calculation. It’s best to use a very conservative long-term estimate for growth and the current P/E ratio in calculating the PEG ratio. This reduces the risk of an unpleasant surprise and minimizes the effect of uncertainty in your growth estimate.
The article Be Careful With Forward P/E And PEG Ratios originally appeared on Fool.com and is written by By Timothy Green.
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