The Folly of PEG Ratio

Price Earning Growth (PEG) Ratio is the ratio of a company’s P/E with its growth rate A lot of analysts have concurred that a stock is fairly valued when its PEG ratio equal one This means that if a stock has a P/E of 10 with a growth rate of 10%, then the stock is trading at fair value

How many of you have seen this kind of statement? I have seen it plenty of times and I think it is silly This is a relatively simple reasoning Let’s think of it for a second If a stock will grow its earning for 8%, then to reach fair value, the stock has to trade at a P/E of 8 How about a stock with growth rate of 5%? Its fair value is a P/E Of 5 How about a company with 0% growth? Oh, right According to this theory, the company should have a P/E of 0, or worthless Does this make sense? Heck, no But there are a lot of articles regarding this PEG theory Here are several sources of commonly misunderstood PEG ratio:

http://wwwmoneychimpcom/glossary/pegratiohtm
http://wwwfoolcom/School/TheFoolRatiohtm
http://wwwinvestopediacom/articles/analyst/043002asp

For a 0% growth company, the fair P/E ratio for the company is not 0 Rather, it is a few percentage above risk-free interest rate or a ten year treasury bond If a ten year bond is yielding 46%, then the fair value of a common stock is at 76% yield Inverting this yield, we get a P/E ratio of 132

Anything else is wrong with using PEG ratio to determine the fair value of a common stock? PEG assumes infinite growth rate in earning per share No company can grow at the same rate forever If we assume company A will grow at 10% rate for the next five years and then growth slows to 2% indefinitely, what is the fair value of the common stock using PEG ratio? The answer is it can’t do that PEG ratio is way too simple to single-handedly assign a fair value for a common stock It is misleading and simply wrong to use PEG ratio for our fair value calculation

Common sense dictates that a stock with higher growth rate should be valued at a higher P/E ratio There is nothing wrong with that But using a simple PEG ratio of one as a fair value of a common stock is simply wrong I don’t have an accurate way to calculate this but an estimation can be read on other articles entitled Calculating Fair Value with Growth and Fair Value with Negative Growth

Article Source: http://wwwarticledashboardcom

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