The PEG ratio

[4/10/06] Joseph Khattab decided to back-test the PEG ratio to see whether it really is an accurate indicator of value.

The results? On average, companies with lower PEG ratios outperformed those with higher PEG ratios by a wide margin over the past three years.

His study is pretty flawed though because he took the p/e of stocks in 2003 and divided by the growth rate from 2003 through 2006. The problem is that those growth rates would be unknowable if you looking in 2003 (which he acknowledges).

*** [8/30/13]

The PEG ratio is a simple tool that can be useful in your search for undervalued stocks. But it is far from a perfect metric and is no substitute for doing your own homework.

 This metric was first popularized by Peter Lynch and is calculated as:

Price/Earnings/Growth

According to Lynch, a company that's fairly priced will have a P/E ratio equal to its growth rate. In other words, a stock with a PEG ratio of 1.0 is fairly valued, while a stock with a PEG ratio of less than 1.0 is undervalued and a stock with a PEG ratio greater than 1.0 would be overvalued.

While this seems intriguing and intuitive, remember it is only a rule of thumb. The assertion that a P/E ratio should equal earnings growth is somewhat arbitrary and certainly does not apply to all companies.

Consider a blue chip company operating in a mature industry. Its earnings growth may only be 5%. Does that mean it should have a P/E ratio of 5? What if it pays a huge dividend? [that's why I like to look at PEGY] What about a company with no growth... or even negative growth? [stay away]

There is also no consensus on whether to use a trailing or a forward P/E ratio and whether to use next year's expected growth rate or a longer-term expected growth rate. But this can have a major impact on the PEG ratio calculation.

 I would argue for using a forward P/E since the stock market is forward looking, along with a longer-term earnings growth rate to keep a long-term perspective. However, use the long-term earnings number only with a great deal of caution. That is because the long-term earnings growth rates that analysts publish are often way too optimistic.

A study by J. Randall Woolridge and Patrick Cusatis of Penn State showed that analysts consistently project EPS growth rates much higher than actual growth and that companies rarely meet or exceed their projected EPS growth rates. In fact, over a period of more than 20 years, Woolridge and Cusatis found that analysts' long-term EPS growth forecasts averaged +14.7%, but companies actual long-term EPS growth averaged only +9.1% - almost 40% lower.

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More testing of the PEG ratio

Why PEG Ratio analysis is a silly tool.