How Useful Is the PEG Ratio?

The PEG ratio is one of the most popular valuation tools. It takes about eight seconds to calculate and is much easier than running a discounted cash flow valuation. But the skeptic in me started to wonder: Can something so simple really be useful?

I decided to back-test the PEG ratio to see whether it really is an accurate indicator of value. The results were surprising.

Normally, I'd save the answer until the very end of the article, but let's just get this out in the open: On average, companies with lower PEG ratios outperformed those with higher PEG ratios by a wide margin over the past three years.

To me, that indicates that the PEG is not just a lot of smoke and mirrors. Although it is not a perfect tool (what is?), it is useful for a quick and dirty valuation.

PEG crash course
Before we crunch some numbers, here's a quick refresher on the PEG ratio. Simply divide the P/E ratio by the rate at which you think earnings will grow over the next few years. You can use your own growth estimates or get five-year analyst growth estimates from Yahoo! Finance. If your PEG is around 1, you have a fairly valued company -- or so the legend goes. A PEG much higher than 1 indicates an overvalued company, and a PEG lower than 1 indicates an undervalued company.

Now, the fun part
I calculated the PEG ratio as of March 2003 for more than 1,000 companies. I simply took the P/E ratio in March 2003 and divided it by the actual earnings growth rate from March 2003 through March 2006.

Then I calculated the performance of each stock over the past three years to see whether I could find any correlation between the PEG and stock performance. On average, stocks with a 2003 PEG between 0 and 1 performed much better than the others. Here are the results.

2003 PEG Ratio

Number of Companies (1,316 total*)

Median Return

Average Return

Below 0.00

213

43.9%

69.4%

0.00 - 0.99

583

154.1%

225.2%

1.00 -1.50

193

78.4%

92.6%

1.51 - 2.00

102

60.5%

79.0%

More Than 2.00

225

44.4%

69.4%

*Includes U.S. companies trading on major exchanges with market caps greater than $500 million for which data was available.

My study is not statistically airtight. The results are skewed by having to throw out companies that had negative earnings. However, my sample size is large enough that I feel comfortable calling these results a good guideline for the PEG ratio.

Some things to ponder
Here are a few more interesting tidbits from my study:

  • 92% of companies with PEG ratios of less than 1 beat the market over three years.
  • 68% of companies with PEG ratios of between 1 and 2 beat the market.
  • 47% of companies with PEG ratios greater than 2 beat the market.
  • The best performer was (surprise, surprise) Hansen Natural (Nasdaq: HANS  ) . It had a PEG of 0.08 in 2003 and had gained 5,400% through March.
  • The second-best performer was NutriSystem (Nasdaq: NTRI  ) with a PEG of 0.06 and a gain of 5,200%.
  • Despite a PEG of 0.55, Ford (NYSE: F  ) managed only a 14% gain over three years.
  • Dick's Sporting Goods (NYSE: DKS  ) was "fairly valued" with a PEG of exactly 1, but it still appreciated by 265%.
  • A PEG of 8 didn't stop Select Comfort (Nasdaq: SCSS  ) from appreciating by 266%.

Caveats
The PEG ratio is limited by its focus on earnings growth. For example, Ann Taylor Stores (NYSE: ANN  ) grew earnings at -0.32% over the past three years, but the stock tripled. Altria (NYSE: MO  ) also had negative earnings growth, yet the stock doubled.

These performances point out the shortcomings of the PEG -- earnings growth is not the only thing the market cares about. Revenue growth, cash flow, dividends, debt, and many other factors are also important to value.

Another thing to consider is that the "G" is the crucial part of the PEG. I was able to calculate the exact rate of earnings growth when back-testing. But when you are trying to value a company today, you won't know the rate of earnings growth. You will only have your best guess, or the best guess of Wall Street analysts. Thus, your PEG will be only as good as your inputs.

Finally, the PEG is very useful for small growers like Hansen and NutriSystem, but may be misleading for large, mature companies like Altria and Ford, since sustained growth is less important to their total returns.

Foolish bottom line
I hope my study helps to shine some light on the pros and cons of the PEG ratio. Keep in mind that the PEG is most useful when used to supplement a more thorough discounted cash flow analysis or relative valuation.

To learn more about valuation techniques and undervalued stocks, try out our Motley Fool Inside Value service free for 30 days. There's no obligation to subscribe, and each month, advisor/analyst Philip Durell recommends two undervalued stocks and helps you learn how to find more of them for yourself.

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Select Comfort is a Motley Fool Hidden Gems recommendation.

Fool analyst Joey Khattab does not have a position in any of the companies mentioned.You can only hope to contain the Fool's disclosure policy.


Read/Post Comments (7) | Recommend This Article (148)

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 November 11, 2009, at 11:08 PM, jimpossible2k wrote:

    Great article!

    An even more interesting study (in my opinion) would be to see if a similar correlation could be found using the past growth rate of the companies (prior to March 2003) or by using the forecasted future growth rate (from analysts) since we only know the actual growth rates in retrospect.

  • Report this Comment On November 11, 2009, at 11:09 PM, jimpossible2k wrote:

    Great article!

    An even more interesting study (in my opinion) would be to see if a similar correlation could be found using the past growth rate of the companies (prior to March 2003) or by using the forecasted future growth rate (from analysts) since we only know the actual growth rates in retrospect.

  • Report this Comment On October 17, 2010, at 12:24 PM, PEGformula wrote:

    As submitted to fool.com 5 years ago, a more robust PEG model exists and was developed with adherence to mathematical and economic principles. By going to http://stockmarketproblems.blogspot.com you will find greater description along with a chart showing the application of both the commonly used yet fallible method alongside the mathematically robust method. The model assumes a 5-year horizon of growth with the natural logarithm of 2 factor of successive yearly dampening of the growth rate that provides a slight bias over the golden ratio subtracted by one which then reduces to a not so difficult expression of: (P/(E(1+G)^2))/12. The factor of 12 to normalize the result to 1 for flat growth is based on a fair PE value that may appear to be slightly below the norm of 14 for the S&P500 PE throughout the last century, however it is in-line with how the PE ratio functions in terms of other financial dealings such as real estate investment.

  • Report this Comment On November 05, 2010, at 10:59 PM, PEGformula wrote:

    The math-based PEG formula has been moved to http://stockmarketrealities.blogspot.com

  • Report this Comment On November 05, 2010, at 11:39 PM, ferrariedgardo wrote:

    Great article but need to get some clarification.

    Did you calculate the growth based on the actual growth in the period that you are predicting if so the analysis has a significant bias.

    The orthodox way would be to find what the PEG was in 2003 to analyze if it is a good ratio. Where the growth is based on the expected growth for the years ahead and not based on actual performance.

    The problem with using the actual growth is that it is after the fact and it is actually the cause why the stock grew that much. Basically if the earnings grew at 100 percent per year but the growth expected by analysts was 0% then that stock would have had a very different PEG.

    PLease let me know the exact methodology you used.

    Anyhow I do like the article. Thank you

  • Report this Comment On August 27, 2011, at 3:21 PM, screenerco wrote:

    Screener.co has several variants of PEG ratio that you can use as pre-built screening criteria. Specifically, using:

    Forward EPS

    Normalized TTM EPS

    Normalized Fiscal Year EPS

    TTM EPS

    Fiscal Year EPS

    Contrary to popular belief, there is no "standard" way to calculate PEG. In fact, the methods used by Yahoo Finance and Bloomberg were different the last time I checked. Our philosophy is to support as many different variants as we can.

  • Report this Comment On May 26, 2014, at 7:23 PM, oneilmo wrote:

    Worthless.

    Using the actual PEG reduces this to a backward looking math exercise that informs nothing.

    Of course companies that actually grow (perform) to make the backward looking PEG less than one perform well. Now we know that companies that grow well with lower PEs outperform.

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