How Useful Is the Peg Ratio in Today’s Markets?

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Emily Flippen about the latest headlines from Wall Street. They discuss a legacy Chinese social media company's plans to delist from the exchanges and clarify some confusion surrounding peg ratios. Also, discover what's in store for the fast-approaching holiday season and much more.

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This video was recorded on September 28, 2020.

Chris Hill: It's Monday, September 28th. Welcome to MarketFoolery. I'm Chris Hill, with me today the one and only, Emily Flippen. Thanks for being here.

Emily Flippen: Thanks for having me on, Chris.

Hill: We are going to talk about the holiday retail landscape, because it's getting closer and we are starting to get more data. We're going to talk about the peg ratio, because we never talk about the peg ratio. But we are going to start with one less public company.

Sina Corp, which is the online media company based in China, is being taken private by Charles Chao, who is the Chairman and CEO. The deal is being valued around $2.5 billion. Shares of Sina Corp up about 6%, not quite at the buyout price, but getting there. And all indications are that, yes, the normal approvals will have to kick into place. But this seems like a deal that's going to get done.

What was your reaction when you saw this news?

Flippen: I was surprised because out of all the Chinese companies that I thought could be taken private or otherwise be delisted, move elsewhere, Sina wouldn't have been the first one that I would have assumed bit the bullet. But thinking about it more, I'm not as surprised. This is kind of a legacy Chinese social media company. They spun off their stake in Weibo, which is kind of like the Chinese Twitter, it has an interface very similar to that microblogging platform. So, the stake within itself is really Weibo; that's the value behind Sina, and they made that spin-off. But when you look at the economics behind being listed in China, taking yourself private, potentially listing elsewhere, whether that be Hong Kong or on a foreign exchange, it kind of makes sense. The perspective from a lot of Chinese companies right now, and granted -- again, I did not think that Sina was going to be the first one that we saw bite the bullet, but the perspective from a lot of Chinese companies is that they're simply not getting a fair shake in the markets here in the United States. So, I'm not surprised that this is happening and I don't think this will be the last company that we either see take themselves private, in the case of this CEO and Chairman, or otherwise list themselves on a different exchange.

Hill: Yeah. This certainly is something we've seen more of in 2020 than we've seen the last few years. By my count, we've got more than a dozen Chinese companies listed on U.S. exchanges that have either been taken private or are in the process of being taken private. And this is going to be the most since 2015. I have to believe -- and we studiously avoid politics on the show, but I have to believe the political atmosphere is a healthy percentage of why this is happening.

Flippen: There's definitely a way to have the conversation without making it political, just think about it from the perspective of a Chinese company. If you're doing business, say, your business is solely focused in China, but you're listed on an exchange in a foreign country like the United States, the geopolitical risk that exists there is actually very real for these companies. It may not impact their core business if they're just doing business in China, it's understandable that, why would inter-political situations cause your business to change? It doesn't. But what it does cause a change in is the valuation that your company receives on a different exchange. So, taking yourself private is kind of an extreme reaction. Again, Sina is a little bit of a legacy player here. What we're actually seeing more and more companies do is actually just dual-list themselves, have a second listing, oftentimes on Hong Kong. Chinese Shopify, if you will, Baozun, recently had a secondary listing on the Hong Kong Stock Exchange. We've seen Baidu, we're hearing rumors about a potential dual-listing from Baidu. That's probably the direction that we're going to see Chinese companies taking, essentially saying we're going to dual-list ourself to reduce the valuation risk that exists with being listed on a foreign exchange.

Where it goes from here is anybody's guess, but from my perspective, this is kind of an understandable reaction to a quickly degrading political situation.

Hill: Our email address is [email protected]. An email from Brian Knowles in Stockholm, Sweden, by way of San Francisco, California. He writes, "Longtime listener, first time emailer. My question is about the peg ratio and how useful it is in today's market. In theory, the peg ratio should easily identify a good long- or short position. However, given the ridiculously high price-to-earnings ratios we see today, combined with lots of COVID-related ambiguity around earnings, are peg ratios a meaningless metric for today's investor?"

Flippen: Before I answer that ending question, I just want to clarify something. No single ratio is going to tell you enough about a company to determine a good long- or short position. We talk about being long-term investors at The Motley Fool. There is not a single ratio or a single metric, any financial metric, that will paint you a whole picture of a business. They should all be used in conjunction with each other. So, when you're looking at a ratio like the peg ratio, you can't determine if a company is over- or undervalued based solely on that ratio. A. you have to compare it to its peers, and when its peers are all trading at sky-high -- if you will -- peg ratios, then that doesn't say much about whether or not that single company is over- or undervalued; but more importantly, you have to look at it in aggregation of both the company and its industry.

So, no single metric clarifies whether or not a company is a good or a bad purchase, in my opinion. But to answer the question about whether or not the peg ratio is kind of outdated, I think that's a really interesting question here. I would argue, yeah, I think it's kind of outdated, mostly because when you look at earnings, right -- so, let's clarify what the peg ratio is, I realize that I've been throwing around "peg," and people may be very confused by that.

The peg ratio is the price-to-earnings ratio over the expected growth rate of a company; essentially what it tells you is the price that you're paying for a single unit of growth in a company. So, when you have a company that's trading at a lower peg ratio than another, theoretically you're paying less for that unit of growth than you are for a different unit of growth. Here's the problem with that. Earnings, right, the price-to-earnings, that's a really managed metric by management. It's subject to a lot of accounting overviews. And ultimately, companies know that investors look at P/E ratios and peg ratios, so they're going to do their best to manage those numbers. It's also really dependent on what type of growth expectations you have. All in all, it makes a really confusing picture about the importance of the peg ratio.

In my opinion, if you're going to be looking at a metric, and as I said before, I'm not really big on looking at any single metric. In my opinion, look at some metrics that look at cash flow, right? Enterprise value to free cash flow is an interesting one, much [laughs] harder to manage for cash flow than it is for earnings. So, when I have to make my choice, I think I lean toward cash flow and I think I lean toward -- yeah, maybe the peg is a little bit outdated here, I don't use it all that often.

Hill: Yeah. And you're absolutely right in terms of, you know, people looking at P/E ratios that are lower. And I think people do this with peg ratios as well, and they basically think, well, this is a low peg ratio, therefore this stock is undervalued. And as you said, and thank you, by the way, for leading right off the bat with [laughs] first of all, all ratios in moderation, don't bet everything on a single ratio. It would be great if there was a single ratio that gave you the complete -- or a single metric that gave you the complete picture of a company and its prospects. If that existed, we wouldn't need any of the others, but that thing doesn't exist. But you know, it reminds me of the old line that sometimes stocks are cheap for really [laughs] good reasons. It's like, oh, this has a really low peg ratio, it's like, yeah, there might be a reason for that.

Flippen: If there was a single metric that was an indicator of success for a company's stock, you don't think management would manage for that number, right? So, the inherent existence of a single metric or a ratio being indicative of the stock price performance works against the intuitiveness of the people [laughs] running that company. Essentially, the moment you find something that works and people figure it out, it stops working. So, I love the idea of looking at a company's financials, getting a sense for its valuation. In my opinion, ratios are probably one of the worst ways to do that, because what you're doing is taking the implicit assumptions in the market and taking it as a given as opposed to making explicit assumptions yourself. What I would encourage all investors to do before looking at things like P/E ratios or peg ratios is to look at the size of the company, make an estimate of what you believe their total market is, right? What's the value of that total market? And then find out what the management strategy is to take advantage of that market. Then you can get a great sense for the size of the company today versus the size of the company a year from now, three years from now, five years from now, even a decade from now. In my opinion, that's how you find great companies at low valuations, [laughs] not looking at metrics.

Hill: We're starting to get more details about the retail landscape as we get closer and closer to the holiday season. Amazon announced that Prime Day, which is typically held in July, is going to be held on October 13th and 14th. And UPS got an upgrade from KeyBanc Capital Markets in the report, sort of citing some of the things that we saw with the most recent report out of FedEx.

Before we get to the broader picture, I don't know about you, [laughs] but when I saw that Amazon announced when Prime Day was going to be, and I say this as a longtime Amazon shareholder, my first thought was, oh, have you got all the shipping stuff figured out? Are all the fulfillment issues figured out? Because I'm really hoping you're not announcing Prime Day and you're still dealing with bugs in the shipping and fulfillment system.

Flippen: I would operate under the assumption that you should expect your deliveries for Prime Day to be a little bit slower than they would have otherwise, but they wouldn't be launching [laughs] Prime Day if it would otherwise impact their ability to serve their core customer base, but more importantly, get the necessities out. That was the reason why they pushed Prime Day initially, it was because essentially the shipping, the fulfillment and logistics were so overwhelmed by the demands for online ordering that they didn't want to overwhelm an already [laughs] overwhelmed system. That within itself could break things, and it impacts the people who are the most vulnerable in society, right? People waiting on their medication, waiting on their toilet paper, [laughs] whatever it is that they're ordering online that they need, it could be impacted.

So, I would operate under the assumption that Amazon, the reason why they pushed it in the first place was because they didn't want to overflow their fulfillment and delivery systems. I would assume that they are not planning -- and they could be wrong -- but they are not planning on overwhelming [laughs] those systems come October. So, in my mind, this is probably a good move on Amazon's part, it will be really interesting to see what engagement looks like for Prime Day, but more importantly, what people are ordering. Because I would imagine what you're demanding in October may be materially different than what you're thinking about back in June or July.

Hill: How are you feeling about the holiday retail season in terms of your optimism? As I said, we're starting to get a couple more pieces to fill out the puzzle. Most recently we had FedEx talking, I would argue, very optimistically about what they're expecting. We're seeing companies come out with the typical, and in some cases higher than last year, numbers in terms of seasonal hiring. So, I would say my optimism has the word "cautious" in front of it right now, but it certainly seems like we might be in for broadly a good holiday retail season.

Flippen: I am also hesitantly optimistic. It's funny, projections for the holidays are all over the place. Actually, I think my favorite report came out earlier this month from Deloitte. And they said they predicted holiday sales growth of 1% to 1.5%. And that was interesting to me. When I dug through [laughs] the report, essentially what they're saying is, we model two scenarios and we think both are probably equally likely. One, where sales are dramatically down [laughs] or really flat, and one where they're up 2.5% to 3.5%. And so, as a result, we're just going to take the middle ground here, right, 1% to 1.5%.

And it gave me a chuckle, because that's how volatile this holiday season is going to be for a lot of consumers. We don't know what unemployment will look like, we don't even know for people who are unemployed or retained their jobs, what their spending will look like. Prime Day will give us some evidence about whether or not people are going to be spending more come the holiday season. I tend to be cautiously optimistic, because I think that holiday travel may be muted, but I think a lot of people who would otherwise travel will be ordering and sending presents online. And that season is going to be dramatically spread out. I think we're probably looking at a holiday season that extends from Prime Day all the way through December, people buying and shipping things on a much more spread-out schedule than they otherwise would have. But it's needless to say that the projections for the holidays this year are all over the board.

Hill: You just reminded me of, it was about this time last year that we got two very different views of what holiday retail 2019 was going to look like. One came from the National Retail Federation, and they put out a pretty rosily optimistic [laughs] projection of what they expected. I'm trying to remember who was on the other side of that, it may have been a Wall Street firm or something like that, but some other well-respected economist came out on the other side and basically said, no, it's going to be half, it's going to be half of that. And the National Retail Federation -- and I took their report, their projections with a grain of salt, because look, that's their business, you know, they want to project optimism. They ended up being right. So, I think for investors who are looking for more pieces to the puzzle to fill out what kind of holiday season we're in for, the National Retail Federation probably has their finger on the pulse better than most.

Flippen: I don't want to be blase about the real impact that we're seeing on the economy right now, though. It's easy for somebody who is sitting behind a screen right now, working remotely, to be like yeah, people are going to spend more, they're going to order stuff online, without recognizing the hundreds of thousands, millions of unemployed Americans, who may continue to be unemployed throughout the holiday season, even with some holiday hiring that we're seeing coming out from bigger firms. The impact on the economy right now is very real for millions of Americans. And what those people choose to do can impact the holiday season. We don't know what that looks like, we don't know if this unemployment or if the economic impact is truly temporary or if this is going to be a situation that takes years to resolve.

Hill: Emily Flippen, always good talking to you. Thanks for being here.

Flippen: Thanks for having me on.

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd, I'm Chris Hill, thanks for listening, we'll see you tomorrow.