The Origin of the PEG Ratio
The origin of the PEG ratio was originally attributed to the author Mario Farina who wrote about it in his 1969 book, “A Beginner’s Guide To Successful Investing In The Stock Market.” However, the popularity of the PEG ratio is primarily credited to Peter Lynch based on his 1989 best-selling book “One Up On Wall Street.” However, Peter Lynch did not specifically talk about the PEG ratio as it is widely used today. On the other hand, he did essentially describe and establish a ratio based on P/Es and growth rates. Here are a few excerpts of what Peter actually said on pages 198 and 199:
“The P/E ratio of any company that’s fairly priced will equal its growth rate. I’m talking about growth rate of earnings here.”
Then a few paragraphs down he introduced the concept and described it as a ratio of sorts as follows:
“In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds.”
However, and here is the interesting part. Most practitioners and devotees of the PEG ratio today base their calculation on an estimate of a company’s future 5-year earnings growth rate. But, Peter Lynch was not recommending that the ratio be based on forward earnings growth. Instead, he suggested utilizing historical earnings growth. Here are his exact words from the next paragraph in the book:
“If your broker can’t give you a company’s growth rate, you can figure it out for yourself by taking the annual earnings from Value Line or an S&P report and calculating the percent increase in earnings from one year to the next. That way, you’ll end up with another measure of whether a stock is or is not too pricey. As to the all-important future growth rate, your guess is as good as mine.”
As I will discuss in more detail later, the PEG ratio is most appropriate for valuing high-growth stocks. Additionally, there are those that suggest that the PEG ratio is best applied to stocks that do not pay dividends because it does not incorporate income received in its valuation calculation. Consequently, there are those that suggest using a modified version of the PEG ratio through adding the dividend yield to the estimated growth rate (PEGY ratio).
The reason I bring this up is because Peter Lynch also had a view on utilizing a modified version of the PEG ratio (PEGY ratio) for dividend paying stocks. However, he actually suggested a calculation that turns the current PEG ratio calculation upside down.
As described above, the standard PEG ratio formula is expressed as the price earnings ratio divided by the annual earnings growth rate (P/E divided by EPS Growth). Peter Lynch suggested adding the dividend yield to the earnings growth rate and dividing that by the P/E ratio. With Peter’s version a higher ratio is better than a lower ratio, which is the exact opposite of how the PEG ratio is used today. Here are his exact words:
“A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, company X’s is 12%), add the dividend yield (company X pays 3%), and divide by the P/E ratio (company X’s is 10). 12+ 3÷10 is 1.5.
Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15% growth rate, a 3% dividend, and a P/E of 6 would have a fabulous 3.”
In conclusion, if the PEG ratio was truly attributed to Peter Lynch as many suggest, then the way it is commonly used today is an upside down version of what Peter Lynch was actually suggesting. Peter Lynch’s version of the PEG ratio would be Annual EPS growth divided by the P/E ratio.
The Risk of Estimating Future Earnings
One benefit of the P/E ratio over the PEG ratio is that the P/E ratio is a more precise calculation. It is more precise because it is typically calculated based on specific reported earnings. However, it is not perfectly precise either. Some P/E ratio calculations are based on trailing 12 month data (ttm), however, that level of earnings is not perfectly precise. In other words, every company is continuing to generate earnings at some level after the last quarter has been reported. Companies only report earnings quarterly, and the earnings report doesn’t typically come out until approximately 45 days after the actual quarter has closed.
At other times, the P/E ratio is calculated utilizing forward earnings. This calculation of the P/E ratio relates more closely to the PEG ratio because forward earnings growth is built into the calculation. Nevertheless, calculations based on a forward estimate of earnings might hopefully be close, but again, not precise. The F.A.S.T. Graphs™ research tool that I will be showing later in this article utilizes a blended P/E ratio calculation. This calculation is based on past, current and the closest forward forecast. Again, it is not perfectly precise, but does tend to average out the difference between past and forecast earnings.
The bottom line is that all calculations based on earnings (or any other metric for that matter) are never perfectly accurate for the reasons stated above. On the other hand, these types of calculations should all be thought of as guidelines within reasonable ranges of accuracy and/or probability.
With these thoughts in mind, one of the biggest criticisms of the utilization of the PEG ratio is the reality that the forecast earnings growth utilized in the calculation could be wrong, and sometimes significantly so. For example, I received the following comment from a reader on part 1 of this series that sums it up nicely:
“Basically this. I can’t even count the number of people I’ve seen cutting down Wall Street analysts as idiots, but then are perfectly happy to cite PEG ratios on their holdings as a reason to keep owning.”
My own view on the matter is that all investing in stocks is done in future time. Consequently, the accuracy of earnings forecasts is an unavoidable risk no matter if they are done by analysts or the individual investor themselves. Nevertheless, since we can only invest in the future, earnings estimates are an unavoidable part of a rational investment decision. My college professor and original mentor put it so eloquently as follows:
“As investors we cannot escape the obligation to forecast- our results depend on it. Our forecasts are not prophecy. We should not merely guess or play hunches. We should calculate reasonable probabilities based on all the factual information that we can assemble. We should then apply analytical methods that are employed based on our underlying earnings driven rationale, providing us reasons to believe that the relationships producing earnings growth will persist in the future.”
Therefore, I contend that criticizing the PEG ratio because it incorporates earnings estimates is a two-edged sword. On the one hand, those utilizing this metric should be consciously aware that the denominator (earnings growth rate) might be completely off the mark. On the other hand, since we can only invest in the future, we are obligated to incorporate forecasting within our decision making process.
