What is the flaw with the Price Earnings to Growth (PEG) Ratio?
For starters, let’s first understand what is the PEG Ratio.
PEG stands for Price Earnings to Growth Ratio. It is calculated by dividing the P/E ratio of the firm by its expected earnings growth.
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For starters, let’s first understand what is the PEG Ratio.
PEG stands for Price Earnings to Growth Ratio. It is calculated by dividing the P/E ratio of the firm by its expected earnings growth.
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For example, if the P/E ratio of a company is 30, and its Earnings (EPS) are expected to grow by 20%, then
PEG Ratio = 30 / 20 = 1.5
Now as a rule of thumb, it is said that
PEG value of 1 is fairly valued,
PEG < 1 is undervalued, and
PEG > 1 is overvalued.
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PEG Ratio = 30 / 20 = 1.5
Now as a rule of thumb, it is said that
PEG value of 1 is fairly valued,
PEG < 1 is undervalued, and
PEG > 1 is overvalued.
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This is where the challenge starts.
The above idea of overvaluation or undervaluation assumes a linear relationship between valuation and growth.
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The above idea of overvaluation or undervaluation assumes a linear relationship between valuation and growth.
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For example, look at the companies below
Company A: P/E 20, EPS growth 20%
Company B: P/E 40, EPS growth 40%
Company C: P/E 80, EPS growth 80%
PEG Ratio states all of them are fairly valued. Because it assumes a linear relationship between growth and valuation.
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Company A: P/E 20, EPS growth 20%
Company B: P/E 40, EPS growth 40%
Company C: P/E 80, EPS growth 80%
PEG Ratio states all of them are fairly valued. Because it assumes a linear relationship between growth and valuation.
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What it fails to consider is that a 20% CAGR in Earnings over 5 years increases earnings by 2.5 times, but an 80% CAGR increases earnings by nearly 19 times over the 5 year period!! Compounding creates a non-linearity.
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Thus, a 80 P/E stock can outperform a 20 P/E stock, if it can exhibit growth at a higher rate over the period.
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Always be careful of consistent compounders while evaluating using PEG. PEG works fine for companies with steady but standard growth rates. For high growth rates, the market will tend to give a premium, since the compounding of earnings could be massive in future years.
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