The PEG ratio – a critical look at growth stocks

The price-to-earnings, or PE, ratio is one of the most widely used investing metrics. It gives you an idea of how much the market is willing to pay for a single pound of a company’s earnings, and is calculated by dividing the share price by earnings per share.

PE Ratio = share price/earnings per share

This means that a lower PE ratio represents better value, you are receiving more profit for every pound you pay. Take the theoretical example below of two similar companies in the same industry;

Scroll across to see the full table.

Assuming both companies are expected to grow at the same rate going forward, then, all things being equal, stock B is better value.

Notice that this is despite stock B having a higher share price. You get a larger share of profits by holding one share in Company B and you are paying less for each pound of profits – just 8 times rather than 10 times. It’s a bit like comparing bags of rice in the supermarket – a higher priced bag could still be better value if you get more for your money.

So far so good.

Unfortunately PE ratios run into problems when it comes to valuing companies that are growing at very different rates.

A growing problem

If Company A is expected to double its profits next year, while Company B’s profits remain unchanged, you would expect investors to be prepared to pay more for Company A. And that’s exactly what happens in reality. High growth companies like Amazon trade on high PE ratios (69.5 in Amazon’s case), while more established companies like Volkswagen are more modestly valued (with a PE ratio of 6.3).

That makes sense, because investors in Amazon will be entitled to a share of a, hopefully, much larger pool of profits in future years. But it also makes a straight comparison of PE ratio pretty unhelpful. Is Amazon overpriced at 69.5 times earnings? Well it’s certainly more expensive than Volkswagen, but perhaps it deserves to be.

This problem can be solved to some extent by comparing companies with similar qualities – as we did in our example – or by comparing a company’s current PE ratio to its historic average. You’ll see us use both these techniques in our share research.

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However, even this isn’t a perfect solution. Companies change over time, so a company might genuinely be worth more today than it was in the past, and even superficially similar businesses can grow at very different rates. This is the kind of problem the PEG ratio tries to solve.

The PEG ratio – a round peg in a round hole

The PEG ratio is designed to allow investors to compare companies with different growth rates. It takes a company’s PE ratio and divides it by the percentage growth in earnings.

PEG Ratio = PE Ratio/% growth in earnings

Once again a lower number represents better value. You are receiving more earnings growth for every pound you pay.

In the table below we’ve added some growth assumptions to our previous examples.

Based on these assumptions Company A is now the “better value” choice. However, some fans of the PEG ratio will go a step further and argue that Company A is objectively undervalued.

Peter Lynch and the 1 PEG ratio

Peter Lynch is one of the most successful and well known investors of all time. He delivered an average return of 29.2% a year whilst running his Magellan fund (incidentally his book “One up on Wall Street” is well worth a read).

He argued that a company’s expected earnings and its PE ratio should be equal. That means a fairly valued company would have a PEG ratio of 1. If the PEG ratio is below 1 the stock is undervalued, and if it’s over 1 it’s overvalued.

Now we don’t think things are quite as black and white as that.

For a start not all earnings growth is equally reliable – people will probably turn up and buy marmite next week come rain or shine, but iron ore prices are more sensitive to economic conditions. Generally we think reliable earnings should be worth more than unreliable earnings.

This kind of specific consideration will inevitably undermine any hard and fast rule of thumb. Even the most useful ratio shouldn’t be looked at in isolation, it only tells you part of the story.

PEG ratio and high growth stocks

However, the PEG ratio is clearly useful. And we think it’s at its best when used as a sanity check when looking at the highest growth stocks.

When companies are growing quickly they command exceptionally high PEs that are well beyond the market norm. It’s often difficult to find useful comparators for these sorts of companies. Judging what is a reasonable rating and what isn’t becomes difficult and that can lead investors to shrug and say “after all, does it matter if a company trades on a PE of 60 or 70?”

Well yes it does. If a PE ratio were to fall from 70 times earnings to 60 times that would knock 14.3% off the share price. Most investors would flinch at that kind of loss.

By working out a company’s PEG ratio, investors can get a clearer idea of whether the company’s growth prospects justify its price. We’re not necessarily talking about Peter Lynch’s ‘PEG of 1’ rule here. Simply comparing PEG ratios across a range of high growth companies can help weed out some of the more euphoric valuations that appear from time-to-time.

Investors should remember that no ‘quick fix’ investment tip will work in all cases, and this is no exception. The PEG ratio is nonetheless a useful tool in any investor’s armoury.

This article isn’t personal advice. If you’re not sure an investment is right for you seek advice. Investments, and any income they paid, will rise and fall in value, so you could get back less than you invest.

All yields are provided from Refinitiv and correct as at 16/01/2020.

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