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Putting PEGs in Practice

A Quick Analysis Tool

 Daniel J. Boyle CFA Bookmark and Share

What is the PEG ratio and why is it useful? The PEG ratio is simply the price-earnings ratio of a stock divided by its projected earnings growth rate. It’s a quick and dirty statistic that approximates the analytical insight that can be gained by performing the much more complicated analysis of discounted cash flow.

For example, a stock with a P/E of 15 and projected earnings growth of 10 percent would have a PEG of 1.5. A PEG ratio below 1.0 usually indicates an undervalued stock; between 1.0 and 2.0, a fairly valued stock; and over 2.0, an overvalued stock.  
One study performed by The Motley Fool’s Joseph Khattab in April 2006 sheds light on the PEG ratio’s usefulness. Khattab calculated the P/E ratio as of March 2003 for 1,316 companies with market capitalizations of more than $500 million and divided the P/E by the actual earnings growth rate for that company recorded over the next three years. He then calculated the return of each stock over the three-year period.  
Khattab found that as the PEG ratio increased, fewer companies were able to outperform the market. Of the firms with PEG ratios of less than 1.0, 92 percent beat the market. That’s compared with outperformance by 68 percent of companies with PEG ratios of between 1.0 and 2.0 and 47 percent of companies with PEG ratios greater than 2.0.
In discussing the shortcomings of his study, Khattab points out that he was able to calculate the actual earnings growth, but you don’t have this luxury when considering future growth. “Thus, your PEG will be only as good as your inputs,” he said.
“The PEG is very useful for small growers like Hansen and NutriSystem,”  he adds, “but may be misleading for large, mature companies like Altria and Ford, since sustained growth is less important to their total returns.”

Daniel J. Boyle, CFA, is vice president of the investment management firm Seger-Elvekrog of Novi, Mich. He’s also a member of the magazine’s Editorial Advisory and Securities Review Committee and co-author of the Investor Advisory Service newsletter. The author and/or clients of his firm may have positions in some stocks mentioned in their articles. No investment recommendations are intended.

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