|
|
|
The "PEG Ratio" (or P/E ratio divided by growth rate) is commonly used to identify undervalued stocks. The following discussion points out that PEG can be quite misleading if not applied cautiously. The discussion is taken from:
Damodaran, A. (1996) Investment Valuation, pp.296-9 (Wiley: 0-471-11213-5). (Emphases are added.)
Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. In its more general form, the ratio of PE ratio to growth is used as a measure of relative value, with lower values believed to indicate undervaluation relative to other firms.
Peters (1991) provides a simple test of this proposition by classifying firms into deciles based upon the ratio of PE ratio to expected long-term growth, for every quarter from January 1982 to June 1989. The lowest PE/growth decile outperformed the market in 26 out of the 30 quarters for which returns were measured and earned significantly higher returns than the Standard and Poors 500. The compounded return over the period was 1,536% for the lowest PE/growth decile, while the return on the S&P 500 index over the same period was 356%.
The PE ratio of a high-growth firm is a function of the expected extraordinary growth rate; the higher the expected growth, the higher the PE ratio for the firm. The PE ratio can be graphed as a function of the extraordinary growth rate. In Figure 14.1, as the firm's anticipated extraordinary growth rate in the first five years declines from 25% to 8%, the PE ratio for the firm also decreases from 28.75 to 15.
In its simple form, there is no basis for believing that a firm is undervalued just because it has a PE ratio less than its expected growth rate. This relationship may be consistent with a fairly valued or even an overvalued firm, if interest rates are high or if a firm is of high risk.
The following example expands on the previous example, where under the initial assumptions about interest rates and risk, the firm had a PE ratio of 28.75, which was greater than the expected growth rate. It evaluates the PE ratio as a function of the level of interest rates and of risk, as measured by betas.
In Figure 14.1 the Treasury bond rate used was 6%. The effect of increasing the Treasury bond rate on PE ratios is examined in Figure 14.2. As illustrated in the graph, the PE ratio for this firm is lower than the expected growth rate when the Treasury bond rate is greater than 7%, though it is not undervalued. For instance, the PE ratio will drop to 11.96 if the Treasury bond rate increases to 10%, well below the expected growth rate of 25% in the first five years but still correctly valued.
A similar analysis can be done relating the PE ratio to the beta of the firm. In Figure 14.3, the PE ratio will decline as the beta is increased, and this relationship is summarized in the graph. In this graph, as well, the PE ratio for the firm will be lower than the expected growth rate if the beta of the firm exceeds 1.10, even though it is not undervalued.
The danger of concluding that a firm is undervalued just because its PE ratio is less than its expected growth rate is that it may be the wrong conclusion for high-risk (high-beta) firms or when interest rates are high.
In its relative form, where firms are ranked on the basis of the ratio of PE ratio to expected growth, the rankings will provide a measure of relative value, if:
(a) The length of the high-growth period is the same for all firms.
(b) All firms are of equivalent risk. If the model used is the Capital Asset Pricing Model, all firms have the same betas.
If these assumptions are not fulfilled, however, a direct comparison of the ratio of PE to expected growth may not be justified because a higher-risk firm should be expected to have a lower PE ratio than another firm with the same expected growth rate but much less risk. Similarly, the PE ratio for a firm where high growth is expected to last five years will be lower than the PE ratio for a firm where the same high growth is expected to last ten years.
Consider two firms with the same expected growth rates of 25% for the first five years and 8% after that, the same payout policies (payout ratio in the first five years of 20% ; 50% thereafter), but different levels of risk (beta of 1.0 for the first firm and 1.5 for the second). The PE ratio of the safer firm will be higher than the PE ratio of the riskier firm at every level of growth, as illustrated in Figure 14.4.
Peters, DJ. (1991) Valuing a growth stock. Journal of Portfolio
Management 17:49-51.
If you have questions or comments, write to: DIGnet@mindspring.com.
Return to Home Page of Diversity Investment Group
Diversity Investment Group | Atlanta, Georgia, USA | DIGnet@mindspring.com