Now that we consider valuation with every purchase here at Maker Central, the right method of valuation is at issue. Just yesterday, Matt and I were arguing over whether a YPEG (year-forward price/earnings/growth) ratio or market premium valuation was better. Today, I'm taking a look at the arguments for both.

Rather than reinvent the wheel, I suggest you read the following evergreen articles below. They are short and entertaining explanations of PEG (same as YPEG, but using trailing-12-month earnings instead of projected earnings) and YPEG ratios:

The PEG and YPEG ratios are founded on the principle that a company should trade at a multiple, an earnings multiple that is, roughly equal to its growth rate. A PEG or YPEG of 1.0 is the mathematical result of this theory. For example, if Company XYZ is trading at \$20 per share and next year's earnings are estimated to be \$1.00 per share, XYZ is said to be trading at 20 times next year's earnings (\$20 / \$1.00 = 20). If XYZ's growth rate is estimated to be 20%, then it would have a one-year YPEG of 1.0. The calculation goes like this: Divide the forward P/E of 20 by the estimated growth rate of 20. Simple.

But nothing having to do with equity valuation is ever simple. First off, the YPEG is only a decent tool if the earnings assumptions are reliable and that is where we run into trouble. As I stated in a recent Fool's Den research article, visibility into near-term corporate earnings stinks. Earnings estimates are never more than calculated guesses, but in a market environment like today's, earnings estimates are more like prayers or wishful thinking. The truth is, no one knows when this slide will stop and earnings estimates will return to their normal level of visibility. Until the market settles down, relying on near-term earnings estimates is as Wise as planning your July vacation on today's weather reports.

There is also a problem applying these ratios to companies like semiconductor manufacturers, airlines, utilities, and financial companies because they are cyclical. PEG and YPEG ratios are not much use in valuing large, well-established companies either because they tend to trade based on factors other than growth rates like great management, expanding possibilities, and sustainable competitive advantages. Sound familiar? If not, you're obviously not enrolled in our current Art of Rule Maker seminar, so stay tuned to this column for a lot more on these Rule Maker qualitative criteria.

So, now that I have indulged Matt by dispelling my own argument to value our Rule Makers based on growth rates relative to price, how do we value these industry leaders?

Matt proposes a simple yet practical approach to valuing our Rule Makers over a five year horizon: Apply a discount or premium multiple to a stock based on the average market multiple. Deciding which market multiple to use then becomes the next task. We'll get to that in a moment, but first let me introduce you to Barra Inc.'s (Nasdaq: BARZ) website. Barra is a global investment and technology research company that provides portfolio and enterprise risk management systems to individuals and institutions. Its site has some wonderful market index statistics that can be used as measuring sticks for long-term forecasting.

The most useful page is the S&P/Barra Fundamentals page that contains current and historical statistics such as market capitalization, P/E multiples, price-to-free cash flow (P/FCF), and implied five-year growth rates for the S&P 500, the growth and value segments of the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600. Data goes back monthly to 1977. (Isn't the Internet great?! Just a few years ago, information like this would have cost an arm and leg and was available only to large institutions.)

Pull up this page (Go on, do it!) and you will notice that the P/E multiple and P/FCF (price-to-free cash flow) numbers are relatively close. By downloading the historical information and doing a little spreadsheet magic, I discovered that this relationship has held true for the recent past as well.

```       Average P/E Multiple
S&P 500   Growth    Value
96-01    26.9      36.7      21.0
91-01    23.7      28.7      21.1
86-01    21.1      25.2      18.7
81-01    18.5      22.1      16.3
77-01    16.9      20.3      14.8

Average P/FCF Multiple
S&P 500   Growth    Value
96-01    26.2      38.4      18.0
91-01    22.9      31.2      17.0
86-01    20.4      27.3      15.3
81-01    18.5      24.8      14.0
77-01    17.8      23.4      13.6
```

Since many investors (including me) are used to thinking in terms of P/Es rather than P/FCF, this close correlation is good to know. By using the charts above, we can make an estimated guess at P/E and P/FCF multiples in the future. Of course, I must throw in the line that past performance is no guarantee for the future, but it is the best long-term prediction tool we have. Let's use it to value semiconductor giant Intel (Nasdaq: INTC).

We will use free cash flow (FCF) to avoid basing our evaluation on distorted earnings and because it more accurately represents Intel's fundamental operations. Intel's trailing-12-month FCF was \$6.1 billion. Multiplying the FCF estimate by an estimated five year annual growth rate of 16% (based on estimates by Cahners In-Stat), we get \$12.8 billion (\$6.1B x 1.16^5 = \$12.8B). Next, we need to multiply this future FCF by a multiple from the chart above.

Based on Intel's dominant market share, cash hoard (\$14 billion), and manufacturing prowess, it definitely deserves a premium to the market. And it unquestionably should be considered a growth stock. Therefore, a multiple of 30 seems appropriate because it falls between the five-year (38.4) and 15-year (27.3) P/FCF averages and yet implies a premium over the 20-year average (24.8). Thirty times the future FCF estimate of \$12.8 billion divided by the outstanding number of shares (6.9 billion) yields a per share price estimate of \$56 in five years. That is double the current price of \$28 and therefore conforms to the 2x/5y Rule Maker criteria. Voilï¿½!

Todd Lebor has never read the Kemp-Roth tax cut or watched the Fox News show "The O'Reilly Factor" and thinks M. Trigg should lose the colored socks. At the time of publication, Todd owned shares of Intel. His other holdings can be found online along with the Fool's complete disclosure policy.