Price Earnings to Growth by the Numbers (Part 1 of 2)

The Price Earnings to Growth ratio is often relegated to “rule of thumb” status and doesn’t get much press despite that fact that it combines two of a stock’s most important fundamental attributes – the price to earnings ratio and forecasted earnings growth.

One main issue with this metric is the fact that it is not much more than an arbitrary combination of two values which don’t even have the same units. As a result, it’s hard to pinpoint exactly what the PEG ratio signifies outside of allowing a first-glance look at whether or not a company warrants its high P/E ratio. But, with a little ingenuity, maybe we’ll be able to extract some more use out of this handy little metric.

A Measure of Market Valuation Tendencies
We’ve often heard of P/E being used as a method of gaging the market’s current overall valuation. For example, if the average S&P P/E is above 15, people hoot and howl about an overbought market. If it’s below 10, we wonder what the hell is going on. PEG offers a similar look at what the market is willing to pay for perceived growth at any specific time.

Using the S&P 500 as a basis, we find that PEG ratios are distributed as follows:

S&P 500 PEG Distribution
click image for full size

90% of all PEG ratios fall between 0 and 2.5 with 10% being above this. The distribution within the 0 to 2.5 range looks roughly normal and thus allows us to do a few basic statistical calculations.

S&P 500 PEG Ratio Analysis
Mean 1.26308
Median 1.22
Standard Deviation .4285
90% Confidence Interval 1.81 – .71

Thus, it looks as if the market is currently paying somewhere between a 1.2 and 1.3 multiple for growth, though if we assume that PEGs for an average company can be normally distributed, a PEG anywhere between .71 and 1.81 is not unusual. Granted, in the case of fundamental valuation metrics, the assumption that this number will somehow be randomly assigned is a dubious one at best. Furthermore, the .71 – 1.81 range is so large that it provides very little overall benefit to our understanding of the stock in question other than that most seem to have normal valuation relative to growth.

For those wondering, if outliers were added back into this analysis, mean PEG would rise to 1.52 but median PEG would rise only to 1.27 which would seem to say that there are a small number of outliers which skew PEG ratio distribution significantly. We can likely assume that these extreme PEG ratios are due to extraneous circumstances and not to traditional valuation.

What did we learn here? Well, for one thing, it would seem that PEG ratios do not tend to 1 as is the general rule of thumb. That being said, the other general rule that a PEG ratio greater than 2 is “overvalued” seems to be corroborated by our analysis. Thus, it would seem that we’ve narrowed the usable range of the PEG ratio to between .71 and 1.81 and with a critical value around 1.25. Obviously, this analysis has less to do with true valuation and more just a look at the general range that investors are willing to pay for their stocks. I admit that the analysis is crude and makes some assumptions which may be suspect (let me know if you feel that any part of this post is glaringly weak), but I think the overall look allows some insight into the usefulness of the PEG ratio and should help you to make more informed decisions when using it.

In the next post, I plan to discuss how to use the PEG ratio as an active valuation metric as opposed to simply a screening metric. We’ll look at discounted earnings/cash flow analysis and risk premiums, and try to tie it to growth in order to create a more accurate model for predicting fair-value PEG ratios. Or, at least we’ll try. To tell the truth, I haven’t done this quite yet and it may turn out that there is no such thing as a fair-value PEG ratio. Your guess is as good as mine. Feel free to post your thoughts on how you might go about creating an “absolute PEG model” for valuing stocks.

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[...] of particular interest to me are P/E and PEG (see article: PEG Analysis). Also, because many of these businesses use significant amounts of debt to finance growth, some [...]

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