Small Cap Foolish 8 Putting a Price on Growth

The classic P/E to growth ratio, or PEG, can be a valuable tool for small-cap growth investors if used to supplement a comprehensive valuation analysis. One interesting twist on the PEG ratio is to use growth in cash flow in addition to growth in reported earnings per share to get a better sense of the true growth rate of a given stock.

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By Zeke Ashton
March 18, 2002

The Foolish 8 Small Cap strategy, as you probably already know, is designed to find small, fast-growing companies (those with sales and earnings-per-share growth rates higher than 25%) and that meet our criteria for liquidity, profitability, insider ownership, and a couple of other qualities that we like to see in our small-cap stocks.

In any given month, the companies on the Foolish 8 list may have P/E ratios ranging anywhere from 9 to well over 100, and often times, the growth rate of the former may be higher than the growth rate of the latter. That being the case, an investor would be smart to buy the company on the list with the lowest valuation, and to let the company with the stratospheric P/E pass, right?

Well, it doesn't exactly work that way. In fact, in doing research on the performance of the various companies on previous Foolish 8 lists going back to 1998, I came to the conclusion that companies on the list with high P/E ratios did just as well as those with low P/E ratios. With small-growth companies, the most important factor for success appears to be simply the ability of the company to keep growing. Does that mean that I think valuation doesn't matter? Not at all -- I still believe that valuation is key to buying any stock � small-cap growth or otherwise.

Tools for small-cap valuation
One valuation ratio that is especially useful in small-cap growth investing is the P/E to growth ratio, or PEG. The advantage of using the PEG is that it combines valuation with expected growth. For example, if a stock is trading at 20 times earnings, and is growing at 40% per year, then it would have a PEG ratio of 0.50. If the same stock was priced at 40 times earnings, it would have a PEG ratio of 1.00.

There is an old Wall Street axiom that states that the fair price for a growth stock is equal to its growth rate. In other words, it should have a PEG of no more than 1.00. In the original Motley Fool Investment Guide, Tom and Dave Gardner recommended that small cap investors aim to pay half price for small-cap growth stocks -- that is, only buy when the PEG ratio is at 0.50 or less, and in the case where you've found what you believe to be a company with outstanding prospects, allow yourself to pay up to 0.65.  The same tome recommended that you watch stocks in a range of 0.65 to 1.00, think about selling at 1.00, and sell (or even think about going short) at 1.40. 

In the past few years, the PEG ratio hasn't gotten much love here at The Motley Fool, and I'd like to re-visit this tool today. The PEG does have its limitations, and I certainly wouldn't prescribe any tool as a one-stop decision maker for growth investors. On the other hand, I have always liked the PEG, and I think that it does play one especially valuable role -- it provides at least some valuation discipline in an area where it is not easy to get.

In my own investing I use the PEG as one of many other data points, and routinely flout the recommended buy and sell points noted above. Nevertheless, I suspect that if I were to follow the discipline religiously -- paying no more than a PEG of 0.50 for growth stocks and then selling them at some point above 1.00 -- I'd do alright. 

Problems with the PEG
There are some problems with the PEG, though. The first is the issue of how to calculate the growth rate, and for what time period. There are many financial websites that publish the PEG ratio for stocks based on one-year forward earnings estimates, and I think that's probably a decent place to start, if you plan no more than a one-year holding period. If you subscribe to our goal of aiming to buy small-cap stocks with the potential to double your investment in three years, it makes sense to use a three-year growth rate. But where do you get three-year growth rates?

I personally recommend that you research a company well enough to develop your own estimates of the potential three-year growth rate -- and keep those estimates conservative. In addition, I've learned th