RSS feedTo get a better understanding of the PEG ratio, we should look at the underlying factors in evaluating price-to-earnings and growth. To do this, we will start by making some assumptions. These assumptions may not be entirely representative of real life, but they will help to provide a baseline for the analysis and give some direction should you want to try to do a more rigorous analysis.
Basically, we’re going to do discounted earnings analysis making the assumption that long-term earnings and cash flow should be relatively similar. Thus, we can calculate a fair value for the company based on earnings and use this to establish fair value P/E multiples.
Thus, for a no growth company we have the following equation:
from this we can quickly see that we can get a no growth P/E for any discount rate simply by dividing both sides by E to yield:
Using standard discount rates of 8, 10, and 12 percent, we get no growth P/Es of 13.5, 10, and 8.3. Here’s we find one of the main fallacies of the PEG ratio. As P/Es can clearly exist reasonably for a company which is not growing its earnings. A no growth company trading at a P/E level below 8.3 is likely to provide significant value to its investors provided it has begun returning earnings in the form of dividends. The PEG ratio for such a company would be either non-existent or near infinite suggesting a poor value.
Now, let’s look a company which is growing its earnings. The discounted earnings would be as follows:
And, predicted P/E:
Clearly, if we were to divide this by g, we would get a target PEG ratio. Here, we hit a quandry of sorts. The g term in the PEG ratio is typically the consensus estimate for next year’s growth. The g term in our discounted earnings model is the long term growth rate for the company which cannot exceed the required rate of return as logically the long term growth rate ought to be about equal to that of the overall economy. In the US, this amounts to about 3%. As it is near impossible to project out a company’s earnings growth to the point that it’s earnings fall in line with the economy. In fact, many companies will re-invent themselves before they allow such a thing to happen.
It seems that it is here that my absolute PEG calculations hit a dead end. That being said, I think we’ve done a lot today and I may continue this series next week. What have we learned? Well, first and foremost there clearly is a mismatch between Price to Earnings and Growth from a units standpoint. It is clear from our analysis of a no growth company that fair value P/E can exist even when growth does not. The key now is to determine if there is a usable range for the PEG ratio or if maybe the only thing we can do is use it as an indicator of relative value as discussed in the previous post on the PEG ratio.
I’ll take the weekend to think of how to better analyze the PEG model we developed using discounted earnings analysis and will report back on Monday. Also, today is the last day for you all to comment in attempts to win a free book. The leader right now is “TheWildInvestor” who has commented once since the free book contest began. Suffice it to say, I’m a little sad.
