Does the PEG Ratio Really Work?

Back in 2006, a fellow Fool penned an article: "How Useful Is the PEG Ratio?" The author wanted to figure out whether the PEG ratio actually works, and went about it by backtesting the performance of following PEG rules of thumb.

In case you're wondering, PEG stands for "price-to-earnings-to-growth." It takes the well-known price-to-earnings ratio, then divides it by the company's growth rate. The rule of thumb is that your best investment opportunities will come from stocks with PEG ratios between 0 and 1.

But there was a problem
However, PEG gets a little tricky when we try to find consensus about which price-to-earnings ratio you should use, forward or trailing. Similarly, some followers think that using actual, historical growth is the best bet, while others use projected future growth.

In the 2006 article, since the author didn't have access to forward growth estimates from 2003, he instead used actual growth between 2003 and 2006. Unfortunately, that didn't do a great job of proving whether PEG was a good tool. It only proved that companies that actually grow well in relation to their past valuation will perform well -- a somewhat different matter.

But I liked the idea of putting numbers to the PEG, so I thought I'd take another shot at it. Since I don't have analysts' growth estimates for all stocks in 2003, either, I used actual three-year trailing growth as of the beginning of 2003.

Here's how the data shook out:

Source: Capital IQ, a Standard & Poor's company.

Bam! That's beautiful. It's a slightly different approach, but the same great results. It would appear from this dataset that buying stocks with a PEG ratio between 0 and 1 is a good recipe for outperformance.

Rather than stop there, let's see how well the formula would have worked from that point forward -- that is, 2006 to 2009.

Source: Capital IQ, a Standard & Poor's company.

Yikes.

To be sure, the three years between 2006 and 2009 were simply a dismal time for the stock market. But like a big, fat zit right on the tip of PEG's nose, it's dreadfully obvious that our favored zero-to-one group was the worst performer here.

Ok, so that didn't work out, but maybe PEG's got its groove back more recently. Let's see how it performed between 2008 and 2011.

Source: Capital IQ, a Standard & Poor's company.

Not exactly a resounding redemption for PEG. The 0-to-1 group wasn't the worst performer this time, but it wasn't the best, either. Indeed, the supposedly "avoid at all costs" above-two group managed to outpace all the others this time around.

The lessons from a failed PEG
I was intentionally simplistic with my calculation of PEG. I know there are tweaked versions of the ratio, but many people are drawn to PEG because of its seeming simplicity. So perhaps the 'roided-up versions of PEG might perform more admirably.

Additionally, as noted, I used historical growth. PEG may work better if it's used with projected future growth. Of course the problem with expected future growth is that the numbers often used come from Wall Street analysts, and relying on expert advice has its own pitfalls.

My main takeaway from this, though, is that PEG, like most other simple rules of thumb in investing, can be a good starting point -- but nothing more. While blindly following PEG may yield great results in some periods, in others it will torpedo your portfolio. And that's just not the type of gamble that I'm interested in.

Bank of Ireland (NYSE: IRE) is a perfect example of why PEG doesn't work so well as an absolute guide. At the beginning of 2008, the bank had a trailing earnings-growth CAGR (that's compound annual growth rate) of 20%, and its stock was trading at a meager 3.5 times trailing earnings. Of course, the 20% annual growth was fueled by the crazy lending in Ireland, and the low P/E owed to investors looking ahead to an earnings cliff in the global banking industry.

B of I isn't in great shape today, but does have a shot at staving off further government ownership. But will it make that 2008 investment profitable? Maybe if you measure your returns in light years.

A start, not a finish
I still like PEG. It actually has even more blemishes than what we've discussed here, but at the end of the day, it's a measure of valuation, and value-focused investors like me appreciate anything that can point us toward bargains.

With that in mind, here are a few companies that fall into the 0-to-1 PEG range today. Just to cover all of my growth bases, I only included stocks that have a 0-to-1 PEG based on both three-year trailing and five-year projected earnings growth.

Source: Capital IQ, a Standard & Poor's company, and author's calculations.

Once again, these aren't recommendations or guaranteed slam-dunk investments. But these five stocks could be very interesting opportunities. Dig in further and figure out whether the growth is for real and the valuation is truly attractive. And when you do find that big winner, give yourself and your hard work -- not the PEG ratio -- the credit.

"Buy low and sell high" is the mantra of any good value investor. Unfortunately, most companies fail miserably at it.