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Dismantling the PEG Ratio

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Ah, the PEG ratio. An approach to valuation celebrated by lovers of growth stocks, including some at the Fool, the PEG ratio is typically defined as a company's trailing P/E ratio divided by analysts' five-year estimates of earnings growth. The ratio has won over many fans because:

  • The inputs can be quickly and readily found on nearly any financial site.
  • It is relatively intuitive.
  • It doesn't require any complex math.

Conventional wisdom states that if a company's P/E ratio is roughly on par with its growth rate, its stock is about fairly valued. If a company's growth rate is higher than its P/E ratio, the stock would appear to be undervalued, and vice-versa.

But there's a catch
The PEG ratio is like Sonny Corleone: Too simple for its own good, and as a result, riddled with holes. To me, the PEG ratio merits about as much consideration when it comes to valuation as tomorrow's weather forecast. Here are seven reasons why.

1. It relies on the P/E ratio
As we've espoused oh-so-many times here before, free cash flow, not earnings (an accounting measure), truly drives economic value. Earnings represent paper profits that can be easily (and legally) manipulated, whereas free cash flow represents bankable profits that can be used to shore up balance sheets, repurchase shares, or pay dividends.

So why not use a price-to-free cash flow multiple in place of the P/E? At that point, you're comparing growth rates of two separate financial measures (free cash flow vs. earnings) and statements (cash flow statement vs. income statement). Apple, meet orange.

2. It looks both ways
Speaking of unmatched fruits, the PEG's numerator and denominator face in opposite directions. The P/E ratio is backward-looking, while analysts' growth estimates are forward-looking. There's a bit of a logical disconnect there, and that asymmetry flares up like an ulcer when you're looking at stocks with volatile earnings.

So why not use a forward P/E? That's certainly a step toward symmetry, but what stock doesn't look cheap when you use a forward P/E?

Take Google (Nasdaq: GOOG  ) . With a trailing P/E of 29 and analysts estimating annualized earnings growth of 30%, Google has a PEG right around 1. But if you replace the trailing P/E with Google's forward P/E of 18, the PEG dips to about 0.6. Suddenly, Google looks like a screaming buy. Using a forward P/E in the PEG ratio strikes me as an awesome way to rationalize just about any purchase.

3. It punishes low-growth stocks
If you buy into the concept that a company's P/E ratio and forward earnings growth should be roughly equal, then how should we play low-growth stocks? At the extremes, that would suggest that a no-growth stock would have no value, or that names like Coca-Cola (NYSE: KO  ) and Johnson & Johnson (NYSE: JNJ  ) should only command single-digit P/E multiples.

4. It ignores dividends
To the detriment of all dividend payers, such payouts are not reflected in the PEG ratio. When a company pays out a dividend, it forgoes reinvesting that cash in its business to fuel future earnings growth. As a result, any growth estimate likely understates a dividend payer's true ability to generate shareholder value. It also means that that low-growth, high-yield stocks will almost always look overvalued via the PEG ratio. That's ironic, given the empirical research showing that investing in such companies is a market-crushing strategy.

5. Five-year estimates are bunk
Studies have shown that analysts are consistently too optimistic when it comes to estimating earnings growth. A recently completed 20-year study reviewed the accuracy of analysts' five-year earnings growth estimates, pegging the average estimate at 14.9%. For those of you scoring at home, that's several times the historical rate of U.S. GDP growth, and about 1.5 times the market's historical return. Pretty illogical, right?

Right. Turns out the average actual annual growth rate for the companies in the sample was only 9.8%. If you're relying on unadjusted analysts' estimates as a key factor in your valuation, you're cooking with bad ingredients.

6. Sample sizes vary
While financial websites readily post five-year average analyst estimates, they don't happen to mention how many analysts contributed to that average. Sound trivial? Often, only one analyst comprises the entire sample of estimates. Without doing further digging, that means you're pinning the key driver of your valuation on a single analyst whose name, firm, and track record you do not know. Yikes!

7. There's no consideration for risk
Consider the PEG ratios of First Solar (Nasdaq: FSLR  ) and PepsiCo (NYSE: PEP  ) : about 1.4 and 1.9, respectively, at yesterday's close. Without further context, a PEG-centric thinker would conclude that First Solar is the better buy. But the PEG ratio doesn't reflect that First Solar's business risk and share-price volatility both vastly outweigh those of PepsiCo. Investors who lean on the PEG as a crutch without considering varying risk profiles are cruising for a bruising.

The endgame
Trust me, I could keep going; I didn't even touch on how the PEG is a linear ratio containing a non-linear input, or how it doesn't control for differing durations of supernormal growth. But enough blathering.

What are the takeaways here?

  • Focus on cash flows, not earnings.
  • Don't rely on analysts' estimates.
  • Never let business risk fail to be a factor in your valuation.

Oh, and did I mention to avoid using the PEG ratio?

Read more about the PEG ratio:

Joe Magyer does not own shares of any companies mentioned in this article. Google is a Rule Breakers recommendation, Coca-Cola is an Inside Value recommendation, and Johnson & Johnson is an Income Investor recommendation. The Motley Fool's disclosure policy takes the cannoli and leaves the gun.

Read/Post Comments (5) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 19, 2008, at 4:21 PM, valu3buff wrote:

    well, crap.

  • Report this Comment On September 19, 2008, at 4:49 PM, TMFCaccamise wrote:

    Joe, you're the Great American Hero.

  • Report this Comment On September 19, 2008, at 6:53 PM, TMFKopp wrote:

    Ditto to Caccamise's comment. Knowing IS half the battle. Go Joe!

  • Report this Comment On September 21, 2008, at 2:47 PM, bulldung wrote:

    Interesting article, schizoid to me, a novice investor, after reading TMF Guide To Investing, that touts the PEG. I am beginning to believe there is no one measure of a company that is best, but as a small business owner, I do understand what free cash flow means and agree it is critical, but not perfect. See NVDA or APPL recently, The market responds quickly to phone problems or failing processors and lawsuits, which will lead to lower future free cash flow if not resolved with integrity, i.e. great management .So, in my Foolish pursuit, I would love to hear the priorities of successful Fools as they form their decisions. Thanks, Bulldung

  • Report this Comment On November 27, 2008, at 9:21 PM, ARJTurgot wrote:

    There is no one answer because there is no one answer. I use the PEG, but it sits right next to FCF/MarketCap. PEG gives me quick and easy comparison to the index.

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