The PEG ratio is a useful shorthand for stock valuation. You get it by dividing a stock's current price-to-earnings ratio by its earnings growth rate. You want the number to be low, but not negative.
Master investor Peter Lynch loves this tool. Here's a nugget from his One Up on Wall Street masterwork regarding simple valuation measures: "In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative. We use this measure all the time in analyzing stocks for the mutual funds."
Lynch didn't make his millions by using ineffective tools, so there has to be some value to the PEG method. But how far will it take you toward beating the market?
As it turns out, PEG ratios can be a great starting point for quick valuation estimates; but this ratio is a far-from-perfect value yardstick. Let me show you why.
If Peter Lynch had been running his mutual funds with worthless tools, he wouldn't have been able to beat the markets for 11 years and establish a legendary legacy. So yes... the PEG ratio he favored has a place in your investing tool belt.
Lynch likes profitable small-cap stocks that come from industries that are so easy to understand that they might put you to sleep. Under the assumption that Lynch picked the right tool for his particular investing style, the PEG ratio should be most useful to value smallish companies that turn a profit without making a fuss.
I grabbed a semi-random sample of 10 small caps from 2010 in industries as exciting as life insurance, plumbing services, casual apparel, heavy manufacturing, and supply-chain management. (Be still, my heart.) With PEG ratios between 0 and 1.0 five years ago, these stocks were potentially undervalued at that time, according to the Lynch theory. Did they bounce back to proper valuations given the luxury of five years of economic development?
It's a mixed bag, but an attractive one nonetheless:
For a sense of perspective, the S&P 500 delivered an 81% return during the following five years. Seven of my sample stocks did significantly better than that, while one essentially landed in the same ballpark as the market index. Only two of my low-PEG candidates disappointed investors.
Building a portfolio of these 10 stocks at the start of 2010 by investing $1,000 in each ticker would have nearly tripled your money in five years. That's a fantastic annual return of 24%.
Most of these stocks did indeed lift their overall value to land at more reasonable PEG ratios. Eight of these stocks now present PEG ratios between 1.0 and 2.0. You could say that these companies unlocked shareholder value by living up to expectations.
Two notable exceptions make the rule. Everyday fashion retailer The Buckle now sits on a staggeringly high PEG ratio, with a P/E ratio 19 times higher than its long-term growth expectations. The stock hasn't raced to sky-high prices, but analysts see its earnings growth slowing down to a crawl. Annual growth rates just higher than the breakeven 0% mark can wreak havoc with the math of valuation ratios.
Then there's hospice-care specialist Amedisys. In early 2010, the company had enjoyed a 60-fold share-price increase during the previous 10 years -- and was about to get slammed by a federal investigation into Medicare fraud allegations. So the five-year growth expectations of that era didn't hold water. The investigation was settled for a $150 million fine last year, but the stock hasn't recovered from its brush with legal problems.
Amedisys is back to a low PEG ratio of 0.5, meaning that healthcare analysts expect the company to outgrow its currently low valuation.
I got lucky with my limited low-PEG sample, though. Outliers like Buckle and Amedisys start to expose the weaknesses of the PEG ratio. I looked at analyst-provided growth estimates in order to keep a long-term focus on my investigation. But in doing so, I brought in the big, bad "unknown." If you stop there, you're inviting trouble right into your retirement portfolio.
Peter Lynch addresses this in One Up on Wall Street. Predicting the future is never an exact science. "As to the all-important future growth rate, your guess is as good as mine," Lynch says. And that's coming from an acknowledged master of the trade.
You could avoid this by looking at trailing growth figures instead. In fact, that's what Lynch recommended. But then, you're expecting past performance to continue unchanged.
Amerisys already provided an extreme example of why that approach doesn't work. But you never know what's just around the river bend. Past performance never guarantees future results.
Feel free to look at last year's earnings growth, or the average growth of the last five years, or analyst figures for the next quarter, year, or decade. You could do the same thing with price-to-earnings ratios, as well, looking at forward or trailing earnings and ever-changing market prices.
Moreover, this ratio ignores the effects of dividends, large debt and/or cash balances, and much more. Sticking to smaller, uncomplicated companies helps you work around these omissions, but there are always special cases.
Which brings us to...
The simple truth is, there are no surefire rules of thumb that will make you beat the market every time. The PEG ratio is just one of the many flawed tools you might use to arrive at a true investment thesis.
No matter how you bake the PEG ratio, you end up depending on a large set of uncertain numbers. There's just no way around it. To deal with this hard truth, you have to combine this too-simple tool with other approaches.
Don't get me wrong -- PEG ratios can get you started on the right track. See a temptingly low PEG value? Dig deeper to see why it's so darn low. Share prices might be low for a good reason, with no end in sight.
The earnings behind the P/E calculation could be artificially high thanks to an unusual one-time event. Are analysts setting unreasonably high growth targets?
You can -- and should -- chase all of these potential issues right down the rabbit hole. But it will never be as easy as adding another number to your PEG-based investment model. You have to actually look at the business, understand how it works, and figure out why the PEG ratio is running low.
Only then will you be ready to hit that blinking buy button. A low PEG ratio is never a full investment thesis in and of itself; often, however, it's a good starting point for further research. Just make sure you know about the built-in pitfalls.
Anders Bylund has no position in any stocks mentioned. The Motley Fool recommends Carter's and The Buckle. The Motley Fool owns shares of The Buckle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.