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

Wednesday, Nov 23 2011 by
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…

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12 Comments on this Article show/hide all

UK Value Investor 28th Nov '11 1 of 12

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.

Blog: UK Value Investor
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Edward Croft 28th Nov '11 2 of 12

In reply to post #62270

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.

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UK Value Investor 28th Nov '11 3 of 12

In reply to post #62271

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

Blog: UK Value Investor
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m8eyboy 12th Apr '12 4 of 12

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 12

excellent article thanks

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PhilH 12th Jan '14 6 of 12

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

Professional Services: Sunflower Counselling
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Edward Croft 13th Jan '14 7 of 12

In reply to post #80498

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 '14 8 of 12

Thanks Ed!

Professional Services: Sunflower Counselling
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Warranstar 29th Aug '15 9 of 12

Hi Ed and thanks for a very interesting piece. I am finding that some shares have negative values of PEGR. What does it mean when it's negative? Please can you tell me whether a negative PEGR makes a share more or less attractive for buying?

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Edward Croft 31st Aug '15 10 of 12

In reply to post #105566

Hi Warranstar.

The negative PEGRs are driven by negative Beta values. i.e. multiplying by a negative creates a negative. e.g. PaddyPower and Betfair now have negative Betas possibly because they've had a big spike in a period when the market has just collapsed... so the PEGR has turned negative.

Obviously a company with a very high normal PEG, when normalised with a negative Beta would then have a negative PEGR... is this better or worse? That's where the judgement comes in. The stats say owning a low PEG lower PEGR set of companies ought to produce better returns, so maybe it's worth screening for both at the same time.

It's a good point to bring up. We may need to dig into this a bit further !

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PhilH 31st Aug '15 11 of 12

I've been using PEGR for about 18 months as a measure of cheapness in both value and growth shares.

Professional Services: Sunflower Counselling
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Flackwell 2nd Sep '15 12 of 12

I liked the comment

While institutional investors are more sophisticated

So why are so many Investment Trusts perforiming in line/beneath market average ?

And why do so many PI's beat their returns ?

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Edward Croft


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