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 that companies with really outrageous growth rates (some over 100%) aren't going to be able to sustain that kind of growth for anything close to three years -- so don't get carried away by extrapolating recent short-term growth rates over a longer period.

Another problem with the PEG is that it doesn't make any allowance for how stable and predictable a company may grow. Obviously, a company's growth rate is a very fragile element -- and it's not uncommon to see small companies with dynamic growth rates suddenly encounter a rough patch and totally hit the wall. This is where classic qualitative concepts, such as the company's competitive position and management effectiveness, come into play. Obviously, there is just as much art as science to this, and you should adjust your estimate of the company's value up or down depending on your assessment of these qualities.

The cash PEG
If you are looking for an alternative to the classic PEG ratio, which is based upon earnings per share, here's one that I have been playing around with. I call it the Cash PEG, and it's no different from the classic PEG except that it uses cash flow growth instead of earnings per share growth. Because earnings per share can be impacted by all kinds of one-time charges and other factors that don't affect cash profitability, using cash flow can give you a better picture of the true trend of how the business is doing in real economic terms. Because most small, fast-growing companies have to plow back a large percentage of their profits into growth, a high level of capital expenditures can be expected and are not necessarily a bad thing. For this reason, I prefer using operating cash flow growth rather than free cash flow growth for calculating the PEG ratio, though it's worth looking at both figures.

I recommend calculating operating cash flow growth rates, and comparing this to earnings per share growth rates. If you find that the PEG is much more attractive using earnings per share rather than cash flow, that's a potential warning sign that true economic growth is not as good as reported earnings growth. On the other hand, if you find operating cash flow to be growing faster than earnings growth, that's a signal that the true growth rate may in fact be higher than that calculated using traditional earnings per share.