In part 1 of this two-part series found here a reader and advocate of the PEG ratio provided some interesting insights and reasons supporting its use. The whole comment is over 600 words long, therefore, I have simply listed the 5 major points he offered followed by his concluding remarks. His whole comment can be found by following the above link.
“BeatlesRockerTom
Juzt,
Critical point, and easily overlooked, re trend of the PEG.1) I see PE as kind of like a given day’s temp. Ex. In August it may be 95 and in late Jan it may be 5 degrees. (Northern hemisphere, for readers south of the equator).
2) a PEG ratio depends on a future growth estimate. A PE alone is incomplete info because it does not provide sufficient information regarding where the company’s earnings are headed.
3) Using the PEG ratio provides info that a PE alone does not.
4) G, growth, is an estimate of the future, hence cannot be precisely known.
5) The PEG for a company can change over time by changes in the growth estimate and the PE. The relative change in growth over time matters.
I respect those who dismiss the PEG. We each have the right to choose what we feel is best for us. I prefer to use PEG to compare investments, accepting its imprecision, than to not. Investing in stocks inherently accepts the risk of investing for but not being able to predict future growth of returns exactly, in return for the potential to earn more than a CD. PEG gives some information you don’t have in its absence, accepting its imprecision. Assessing the growth trends- the PEG trend- over time provides even more info.”
In my response to the above comment, I promised that I would address his points more fully in this article. Here is my exact response:
“Tom,
Thanks for sharing your perspectives. I will be addressing many of the points you bring up more fully in part 2 where I cover the PEG ratio specifically. Although I do not specifically disagree with most of your points, I do approach the implementation of growth differently. I do agree that it is an important consideration. However, I do not feel that the PEG ratio specifically addresses those considerations. I will try to explain that more fully in part 2.
Regards,
Chuck”
Growth stocks: Best use of the Peg Ratio
Personally, I do consider the PEG ratio a very valuable valuation metric – but only for growth stocks. As indicated in part 1, I like the P/E ratio of 15 as a standard baseline valuation reference on most companies. However, very fast-growing companies (earnings growth above 15%) are clearly worth more than their slower-growing counterparts due to the power of compounding.
As I suggested earlier, as investors in common stocks we can only invest in the future. Simply stated, this implies that we are truly buying future earnings.
The Power and Protection of High Compounding Earnings Growth
The review of a simple compounding table illustrates my points better than words. What actually happens as a result of faster earnings growth is that it shortens the time it takes to double earnings. Therefore, the following compounding table illustrates how an original $1.00 worth of earnings that are purchased today will double more often over a 10-year timeframe when earnings growth is higher. The tipping point becomes rather dramatic at 15% per annum or better.
People that do not understand the powerful force of compounding will often mistakenly assume that a 20% growth rate will produce twice as much future earnings as a 10% growth rate. However, compounding is more about geometry than it is simple mathematics. From the table below, note that $1.00 invested today that grows by 10% per annum does not double until the 8th year. In contrast, $1.00 invested at 20% doubles in the 4th year, and then again in the 8th year. Therefore, doubling the growth rate from 10% to 20% doubles the number of doubles on your earnings in 10 years. This compounding effect is even more dramatic when you look at what happens with various growth rates by the 10th year.
Increase the growth rate to 30%, and that first dollar will double 3 times instead of only once. Consequently, it is easy to understand why Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Compounding is the power; and the higher level of earnings it produces is the protection that high-growth stocks can provide. However, earning high rates of earnings growth over an extended period of time is quite difficult. Few companies are capable of achieving high earnings growth, and therein resides the risk of growth stock investing.
Growth Stocks and the PEG Ratio
When I originally designed the F.A.S.T. Graphs™ fundamentals analyzer software tool, the first formula I implemented was Peter Lynch’s P/E ratio equal to earnings growth rate. As it relates to the commonly utilized PEG ratio, this formula produces a valuation reference line (the orange line) as a PEG ratio of 1. In other words, when I’m looking at growth stocks, I draw a PEG ratio of 1 across the entire graph. So although I in essence utilize the PEG ratio, I use it differently than simply viewing it as a statistic.
I am not a fan of statistics per se; instead, I prefer dynamic models that allow me to evaluate valuation ratios over numerous timeframes. Furthermore, I implement and analyze my version (P/E = EPS growth rate) based on historical earnings growth as Peter Lynch did, and I apply it to future earnings growth as it is commonly utilized today. In my opinion, I consider this a more comprehensive utilization of the metric.
