The PEG Ratio dismantled - or how to buy your growth stocks on the cheap

Wednesday, Nov 23 2011 by
13
The PEG Ratio dismantled  or how to buy your growth stocks on the cheap

While the PE Ratio may be the classic equity investors valuation ratio, with reams of investment literature showing that buying low PE Ratio stocks is an extremely profitable strategy, not everyone wants to spend their stock picking days digging solely amongst the basket cases and recovery plays that low PE investing often uncovers.

Many investors want to buy growing companies, with great stories and prospects, but these stocks often come priced at a significant premium to the market. How do you tell if a growth stock is still a bargain as the valuation and PE rises?

Lynch Mob

Peter Lynch, the most famous of all Fidelity’s fund managers, popularised the PEG ratio as a solution to this in his famous investment book ‘One up on Wall Street’. Taking Walmart as an example he showed that if you can pick up stocks trading at PE Ratios of less than their growth rate you may well have found yourself a bargain. Lynch used the PEG in his range of strategies to rack up an peerless record while managing the Magellan fund from 1977 through 1990 acing the market with a 29% annualised return. Ever since, the PEG ratio has been a standard weapon in the arsenal of most fund managers and smart stock pickers, but while it does have its champions it also has many critics, making it wise for investors to delve a deeper understanding of its limitations.

PEG and PEGY Defined

Traditionally The PEG is calculated by taking the historic or trailing PE Ratio and dividing it by the forecast EPS Growth rate. It can be thought of as a ‘growth adjusted’ PE Ratio, standardising the PE Ratio to allow quick comparison between cheap and expensive companies relative to their growth rates. For example a glamorous growth company on a PE of 20 growing at 30% per year would be on a PEG of 0.66, whereas a company on a PE of 10 growing at 5% per year would be on a PEG of 2 . The theory of PEG investing is that you should aim to buy companies on low PEGs of less than 1 so that you get more growth for your buck.

For Mature businesses the traditional PEG ratio often becomes rather meaningless as these companies tend to have fewer growth opportunities.  But Peter Lynch found away to adjust the PEG Ratio to factor in the more sizeable dividend yields that these companies generally exhibit.  This adjustment  has come to be known as the PEGY. To calculate the PEGY you simply add the dividend yield to the earnings growth rate in the denominator of the PEG equation i.e. PE / (GR + Y). The addition of large dividend yields to slower growth rates  will help bring the PEGY ratio below 1 making mature businesses more likely to rest aside growth stars when screening the market.

Another approach employed by John Neff is to use an average historical growth rate (e.g. the 5 year CAGR), instead of relying on (notoriously unreliable!) analyst forecast assumpions. 

Slater redefines the PEG

Jim Slater, a renowned corporate raider and author who published the popular ‘Zulu Principle’ stock market books in the UK, hugely popularised his version of the PEG during the 1990s educating thousands of British investors in the art of growth stock investing.  But in the process of putting the popularity of the PEG on steroids, he also confused its definition in the minds of many investors by insisting on his own restrictive criteria for its definition.

Slater’s PEG is different to the traditional definition as it uses the Forward PE Ratio rather than the trailing PE Ratio in its calculation. It has often been criticised due to an effective ‘double counting’ of the earnings growth rate due to its use of the forecast earnings both in the forward PE in the numerator and the earnings growth rate in the denominator of the calculation.   Imagine a company that is forecast to grow earnings 30% over the next year, being valued on a current PE of 39 which falls to a forward PE of 30.  Slater’s PEG would be calculated as 1  (30/30%)  but the traditional PEG would be calculated as  1.33 (39/30%).  As a result of this trust in the brokers numbers and future growth,  it’s easy to see how people following Slater PEG on its own could be perhaps be lured into buying stocks that trade on higher historic PE multiples than they might realise.

But Slater decided to take things further and only 'award' PEG ratios to true growth stocks that qualified for a range of additional restrictive criteria such as having a 4 years consistent growth trend.  In adding these additional constraints Slater turned the PEG into more of a stock screening indicator than a financial ratio, and generated a legion of fans in the process.

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In line with most PEG investors, Slater tended not to go chasing stocks on high valuations, sticking to a discipline of buying shares on a PE of less than 20, with limited gearing, good cash-flow and a PEG of less than 1. This style of investing has come to be known as seeking growth at a reasonable price, or a value-growth blended strategy.

Putting the PEG to the test

For such a popular indicator, there has been surprisingly little research published by academics and quants. The original study into the PEG was published in the Journal of Portfolio Management by Donald Peters in 1991 which showed that a low PEG portfolio in the 1980s massively outperformed the S&P500 by a factor of almost 5. But more recent studies have cast a lot of doubt on those results (Sun, 2001) finding that middling PEG portfolios actually did much better than combined low and high PEG portfolio over a longer timeframe, whereas other studies suggest that low PEG portfolios can’t even outperform a simple low PE portfolios!

The Risk Adjusted PEG

A paper by Javier Estrada accused the PEG itself of being one dimensional due to the fact that it takes no account of the riskiness of a company’s share price. By adjusting the PEG by the share’s beta ( derived from the volatility of the share price) analysts can find a far more effective version of the PEG we like to call the PEGR which is calculated as {PE/G}xß .  If you imagine company A being on a PE Ratio of 20 and PEG of 0.5 versus company B on a PE Ratio of 10 and PEG of 0.5. If company B was half as volatile as A, would it be a more attactive investment? The maths would suggest that in general yes. Estrada's study shows that low PEGR portfolios outperform both low PE and low PEG portfolios on a risk adjusted basis, suggesting that it may well be the true king of the value factors. You won’t find the PEGR in many places, but you can find it in our screening definitions on Stockopedia Premium - sign up for the beta to find out more.

Anecdotal Evidence…

Anecdotal evidence does though suggest that low PEG portfolios perform extremely strongly in fresh bull market periods. Mark Slater (Jim Slater’s son) runs several funds and still follows the Zulu strategy closely. His fund was the top performer among funds in 2009-2010 as the market recovered and he put much of thatperformance down to his strict small cap low PEG strategy. It should be noted though that during the last bear market from 2007 through 2008 the fund significantly under performed the benchmark , showing that a strategy linked so closely to a single risk factor such as the PEG cannot beat the market year in year out.

The truth is that the PEG ratio will always have its admirers as its such a simple metric and so easy to understand. Hinging around the magic number of 1, it grabs the attention of growth investors and value investors alike and displays maths that even those with basic arithmetic can understand. As it has such a large following it needs to be well understood and kept close to hand by all stock investors and just might help you pick the future growth stars for your portfolio if you can find them at the genesis of new bull runs.

If you'd like to screen the market using the traditional PEG, Slater's PEG, the PEGY or the PEGR, sign up to Stockopedia Premium as soon as possible for an early invitation.

 

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8 Comments on this Article show/hide all

UK Value Investor 28th Nov '11 1 of 8
1

I like PEGY as it includes the main sources of returns: valuation mean reversion (i.e the PE is typically low), growth and dividend income.

However, I prefer to stretch the ratio out over the long term so that I'm looking at long term growth as well as the price relative to long term earnings. The companies that tend to score well with a long term PEGY ratio are those that have a sustainable business, and perhaps a long term competitive advantage. Of course you still get falling knives here and there like Game Group, but on the whole it's a good place to start.

Newsletter: UK Value Investor
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Edward Croft 28th Nov '11 2 of 8
1

In reply to UK Value Investor, post #1

UKVI - let me know how you like to define the long term PEGY and we'll see if we can add it to our screenable ratios list.

Blog: Follow @edcroft on Twitter
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UK Value Investor 28th Nov '11 3 of 8
1

In reply to Edward Croft, post #2

Hi Edward. I'll send you a message because this ratio is my own special super secret 'Coke' formula.

Newsletter: UK Value Investor
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m8eyboy 12th Apr '12 4 of 8
2

Hi Ed. Good background on the PEG. I agree with Anthony Bolton (the UK's Peter Lynch!) who said:

I realise that PEG ratios are more the domain of the growth rather than the value investor but I’m afraid I can see little logic in the argument that a business at five times earnings growth at 5% a year, one at ten times earnings growing at 10% or one at 20 times earnings growing at 20%, which all have the same PEG, are equally attractive, I would go for the five times earnings growing at 5% every day.

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Jackalope 17th Apr '12 5 of 8
1

excellent article thanks

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PhilH 12th Jan 6 of 8

Like the article Ed.


I've read the Estrada paper on PEGR (or PERG as he calls it) and I was wondering if anyone has suggested an ideal threshold for the value. For example, the suggestion is to aim for stocks with a PEG of < 1

Also I guess Estrada is effectively arguing that PEGR is the one stop shop for valuing both value & growth stocks, hence the True King of Value Factors moniker. I'm wondering if you have a view on that claim? For example, why haven't guru strategies emerged that exploit it?

Thanks in advance
Phil

Professional Services: Sunflower Counselling
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Edward Croft 13th Jan 7 of 8
1

In reply to PhilH, post #6

Most people use PEG ratios with a benchmark of 1 (where PE = Growth rate).

I haven't investigated this more closely, but given that the beta is centred around 1 too, it would make sense to keep this ballpark of 1 in mind where PEGR < 1 is preferable. The addition of the beta into the calculation ought to to swing more less risky shares under the 1 cutoff and vice versa.

I know that some (e.g. Slater) use a lower PEG cutoff and the same could be applied to the PEGR where looking for PEGR < 0.75 could be the start of a promising strategy.

Regarding it's low popularity. I think generally as one travels along the curve of complexity from...
Price -> Price/Earnings -> Price/Earnings/Growth -> Price/Earnings/Growth/Beta ... a lot of the audience gets lost ! A majority of private investors seem to be focused on price rather than value, and often only go as far along the chain as the PE ratio. While institutional investors are more sophisticated, my experience is that most use a traditional qualitative / investment committee framework for assessing stock market value and aren't of a quantitative mindset. That's probably why factors like the PEGR remain rather obscure.

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PhilH 13th Jan 8 of 8

Thanks Ed!

Professional Services: Sunflower Counselling
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About Edward Croft

Edward Croft

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CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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